UNIVERSITY 

OF  CALIFORNIA 

LOS  ANGELES 


SCHOOL  OF  LAW 
LffiRARY 


BOBERT  M.  PEASE 

ATTOBNET  AT  LAW 

808  QUINBY  BUILDING 

TRinity  2087 
LOS  ANGELES,  CALIF. 


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MATERIALS  FOR  THE  STUDY 
OF  BUSINESS 


Materials  for  the  Study  of  Business 


Readings  in  Industrial  Society.     By  Leon  C.  Marshall.    xxiv-|-lf082 
pages,  royal  8vo,  cloth. 

Financial  Organization  of  Society.     By  H.  G.  Moulton.     xxii+790 
pages,  crown  8vo,  cloth. 

Principles  of  Accounting.    By  Albert  C.  Hodge  and  J.  O.  McKinsey. 
xiv-j-390  pages,  8vo,  cloth. 

Law  and  Business.     By  William  H.  Spencer. 

Vol.     I.    Introduction  to  Business  Law.     xviii-1-612  pages, 

8vo,  cloth. 
Vol.  II.     Law  and  the  Market.     Law  and  Finance.    xviii+ 

670  pages,  8vo,  cloth. 

Business  Administration.     By  Leon  C.  Marshall,    xxiv-f- 920  pages, 
8vo,  cloth.  ^ 


IN  PRESS 

Law  and  Business.     By  William  H.  Spencer. 

Vol.  III.     Law  and  Labor.     Law  and  Risk-Bearing.     Law 
and  the  Form  of  the  Business  Unit. 

IN  PREPARATION 

Business  Communication.  The    Worker  in    Our  Economic 

Risks  and  Risk- Bearing.  -,,       ,, 

The    Manager  s    Administration 
Managerial  Accounting.  ^t  Labor. 

Bank  Management.  .  The  Social  Control  of  Business 

Commercial  Cost-Accounting.  ,  n 

,  Government  and  Business. 

The    Manager  s   Administration  tl      dl     ■     t     c     ■             .      r 

f  r-  '  "^    rhystcal    CLnotronment    oj 

of  Finance.  Business. 

The  Place  of  the  Market  in  Our  Traffic  and  Transportation. 

Economic  Society.  The  Psychology  of  Business  Pro- 

The    Manager's    Administration  cedure. 

of  the  Market.  Readings  in  Business  Education. 


THE  UNIVERSITY  OF  CHICAGO  PRESS 

CHICAGO,  ILLINOIS 


THE  FINANCIAL  ORGANIZATION 
OF  SOCIETY 


THE  UNIVERSITY  OP  CHICAGO  PRESS 
CHICAGO,  ILLINOIS 


THE  BAKER  &  TAYLOR  COMPANY 

N£W  TOBE 

THE  CAMBRIDGE  UNIVERSITY  PRESS 

LONDON 

THE  MARUZEN-KABUSHIKI-KAISHA 

TOKYO,  OSAKA,  KTOTO,  FUKUOKA,  BCNDAI 

THE  MISSION  BOOK  COMPANY 

8HAN0BAI 


The  Financial 
Organization  of  Society 


BY 
HAROLD  G.  MOULTON 

n, 
ASSOCIATE  PROFESSOR  OF  POLITICAL  ECONOMY 
UNIVERSITY  OF  CHICAGO 


THE  UNIVERSITY  OF  CHICAGO  PRESS 
CHICAGO,  ILLINOIS 


T 

)9Z\ 


Copyright  losr  By 
The  University  of  Chicago 


All  Rights  Reserved 


Published  January  1921 

Second  Impression  April  1921 

Third  Impression  July  192 1 

Fourth  Impression  October  1921 

Fifth  Impres&ioQ  Febru^y  igsa 


Composed  and  Printed  Ry 

The  IJnIvereity  of  Chicago  Prea 

Chicasu.  Illinois.  U.S-A. 


i^  EDITOR'S  PREFACE 


Collegiate  training  for  business  administration  is  now  so 
widely  attempted  that  the  time  has  arrived  when  experiments 
should  be  conducted  looking  toward  the  organization  of  the 
business  curriculum  into  a  coherent  whole.  Training  in 
scattered  "business  subjects"  was  defensible  enough  in  the 
earlier  days  of  collegiate  business  training,  but  such  a  method 
cannot  be  permanent.  It  must  yield  to  a  more  comprehensive 
organization. 

There  can  be  no  doubt  that  many  experiments  will  be  con- 
ducted looking  toward  this  goal;  they  are,  indeed,  already 
under  way.  This  series,  "Materials  for  the  Study  of  Business," 
marks  one  stage  in  such  an  experiment  in  the  School  of  Com- 
merce and  Administration  of  the  University  of  Chicago. 

It  is  appropriate  that  the  hypotheses  on  which  this  experi- 
ment is  being  conducted  be  set  forth.  In  general  terms  the 
reasoning  back  of  the  experiment  runs  as  follows:  The  business 
executive  administers  his  business  under  conditions  imposed 
by  his  environment,  both  physical  and  social.  The  student 
^hould  accordingly  have  an  imderstanding  of  the  physical 
environment.  This  justifies  attention  to  the  earth  sciences. 
He  should  also  have  an  understanding  of  the  social  environment 
and  must  accordingly  give  attention  to  civics,  law,  economics, 
social  psychology,  and  other  branches  of  the  social  sciences. 
His  knowledge  of  environment  should  not  be  too  abstract  in 
character.  It  should  be  given  practical  content,  and  should 
be  closely  related  to  his  knowledge  of  the  internal  problems  of 
management.  This  may  be  accomplished  through  a  range  of 
courses  dealing  with  business  administration  wherein  the  student 
may  become  acquainted  with  such  matters  as  the  measuring 
aids  of  control,  the  communicating  aids  of  control,  organization 
policies  and  methods;  the  manager's  relation  to  production,  to 
labor,  to  finance,  to  technology,  to  risk-bearing,  to  the  market, 


Vlll 


EDITOR'S  PREFACE 


BASIC  ELEMENTS  OF  THE  BUSINESS  CURRICULUM 

Of  problems  of  adjustment  to 
physical  enviromnent 

a)  The  earth  sciences 

b)  The  manager's  relation- 
ship to  these 

Of  problems  of  technology 

a)  Physics  through  mechan- 
ics, basic,  and  other 
sciences  as  appropriate 

b)  The  manager's  adminis- 
tration of  production 

Of  problems  of  finance 

a)  The  financial  organization 
of  society 

b)  The  manager's  adminis- 
tration of  finance 

Of  problems  connected  with  the 
market 

a)  Market  functions  and 
market  structure 

b)  The  manager's  adminis- 
tration of  marketing  (in- 
cluding purchasing  ana 
traffic) 

Of  problems  of  risk  and  risk- 
bearing 

a)  The  risk  aspects  of  mod- 
ern industrial  society 

b)  The  manager's  adminis- 
tration of  risk-bearing 

Of  problems  of  personnel 

a)  The  position  of  the  worker 
in  modern  industrial  so- 
ciety 

b)  The  manager's  adminis- 
tration of  personnel 

Of  problems  of  adjustment  to 
social  environment 

a)  The  historical  background 

b)  The  socio-economic  insti- 
tutional life 

c)  Business  law  and  govern- 
ment 


Control 

1.  Communicating  aids  of  con- 

trol, for  example 

a)  English 

b)  Foreign  language 

2.  Measuring  aids  of  control, 

for  example 

a)  Mathematics 

b)  Statistics  and  accounting 

3.  Standards  and  practices  of 

control 

a)  Psychology 

b)  Organization  policies  and 
methods 


EDITOR'S  PREFACE  ix 

to  social  control,  etc.  Business  is,  after  all,  a  pecuniarily 
organized  scheme  of  gratifying  human  wants,  and,  properly 
understood,  falls  little  short  of  being  as  broad,  as  inclusive,  as 
life  itself  in  its  motives,  aspirations,  and  social  obligations.  It 
falls  little  short  of  being  as  broad  as  all  science  in  its  technique. 
Training  for  the  task  of  the  business  administrator  must  have 
breadth  and  depth  comparable  with  those  of  the  task. 

Stating  the  matter  in  another  way,  the  modern  business 
administrator  is  essentially  a  solver  of  business  problems — 
problems  of  business  policy,  of  organization,  and  of  operation. 
These  problems,  great  in  number  and  broad  in  scope,  divide 
themselves  into  certain  type  groups,  and  in  each  type  group 
there  are  certain  classes  of  obstacles  to  be  overcome,  as  well  as 
certain  aids,  or  materials  of  solution. 

If  these  problems  are  arranged  (i)  to  show  the  significance 
of  the  organizing  and  administrative,  or  control,  activities  of 
the  modern  responsible  manager,  and  (2)  to  indicate  appropriate 
fields  of  training,  the  diagram  on  the  opposite  page  (which 
disregards  much  over-lapping  and  interacting)  results.  It 
sets  forth  the  present  hypothesis  of  the  School  of  Commerce 
and  Administration  concerning  the  basic  elements  of  the 
business  curriculum  covering  both  secondary  school  and  col- 
legiate work. 

The  present  volume  in  the  series  is  designed  to  give  the 
student  an  understanding  of  the  financial  institutions  which 
the  manager  utilizes  and  which  largely  condition  his  financial 
policies.     It  presents  one  phase  of  his  social  environment. 

L.  C.  Marshall 


AUTHOR'S  PREFACE 

Increasing  interest  in  the  systematic  study  of  financial 
problems  is  everywhere  manifest  since  the  war.  Not  only  are 
the  classes  in  finance  in  our  colleges,  universities,  and  schools  of 
commerce  literally  flooded  with  students;  the  high  schools  are 
also  seeking  to  incorporate  the  subject  in  their  rapidly  developing 
commercial  curricula;  Y.M.C.A.  and  institute  study  courses  in 
finance  are  being  formed  throughout  the  country;  and,  more 
significant  still,  many  business  houses,  recognizing  the  depend- 
ence of  successful  business  management  upon  a  thorough  knowl- 
edge of  financial  principles,  are  now  organizing  special  courses 
for  their  employees  and  officials.  Even  the  business  manager 
who  has  aheady  "arrived"  is  reading  and  studying  financial 
literature  as  never  before.  The  present  volume  is  designed  to 
serve  as  the  basis  of  a  general  survey  course  in  finance  and  to 
enable  the  general  reader  to  obtain  a  clear  understanding  of 
the  nature  of  the  modern  financial  system,  and  of  the  economic 
functions  performed  by  each  of  the  numerous  financial  institu- 
tions— investment  banks,  stock  exchanges,  commercial  banks, 
trust  companies,  savings  institutions,  commercial  paper  houses, 
discount  companies.  Federal  Reserve  and  Federal  Farm  Loan 
institutions,  etc. — ^which  together  comprise  this  system. 

Perhaps  the  most  striking  feature  of  the  modern  economic 
organization  is  the  dependence  of  practically  all  business 
enterprise  upon  borrowed  funds — that  is,  upon  credit.  As 
the  charts  on  pages  134,  136,  and  650  indicate,  the  funds  used 
by  business  concerns — whether  organized  on  an  individual, 
a  partnership,  or  a  corporate  basis — ^must  largely  be  borrowed 
from  the  rank  and  file  of  individuals,  who  purchase  securities 
or  make  deposits  in  savings  or  commercial  banking  institutions. 
Now  the  modem  financial  structure  has  evolved  to  meet  the 
needs  of  this  credit  system — the  origin  and  development  of  all 
the  financial  institutions  of  the  present  time  being  largely 


Xll 


AUTHOR'S  PREFACE 


attributable  to  the  necessity  of  raising  fixed  and  working 
capital  for  the  uses  of  modern  capitalistic  enterprise. 

The  teacher  will  wish  to  know  precisely  where  a  course 
organized  on  the  basis  of  this  volume  would  fit  into  the  economics 
or  school  of  commerce  curriculum,  and  wherein  it  differs  from 
the  traditional  course  in  money  and  banking.  The  answer  to 
the  first  question  may  best  be  given  by  means  of  a  diagram: 


(Survey  Course) 

Financial    Organization 

of  Society 


(Advanced  Specialized  Courses) 

Money,  Prices  and  the  Cost 
of  Living 

Advanced  Banking  Theory 

International  Financial  Prob- 
lems 

Business  Cycles 

Commercial  Bank  Manage- 
ment 

Investment  Bank  Manage- 
ment 

Business  Finance 

Investment  and  Speculation 

Law  of  Bills  and  Notes 

Banking  Law 


The  survey  course  in  Financial  Organization  is  designed  as  a 
one  quarter,  or  semester,  course,  and  is  a  prerequisite  to  each 
of  the  advanced  specialized  courses  in  the  field.  Following  this 
series  of  advanced  or  graduate  courses  would  come  research 
or  seminar  courses  in  each  of  the  various  special  fields  of  inquiry. 
The  primary  purpose  of  a  survey  course  in  financial  organi- 
zation as  a  prerequisite  to  more  advanced  study  is  of  course  to 
give  the  student  a  view  of  the  entire  financial  system  before 
undertaking  a  highly  critical  study  of  any  single  part  of  it; 
each  financial  institution  can  obviously  be  fully  understood 
and  critically  appraised  only  when  it  is  envisaged  as  a  part  of  a 
larger  financial  structure.  All  teachers  will  doubtless  concur 
with  this  doctrine  and  all,  I  fancy,  will  agree  that  for  one 
reason  or  another  it  has  seldom  been  practiced,  largely  because 
of  historical  accident.    All  of  our  so-called  "appUed  "  economics 


AUTHOR'S  PREFACE  Xlll 

courses  have  been  developed,  one  at  a  time,  either  to  meet  the 
need  for  an  elaboration  of  the  theoretical  material  outlined  in 
the  general  introductory  course  in  economics,  or  the  demand 
for  more  practical  instruction  as  a  training  for  business.  Accord- 
ingly, we  have  witnessed  in  the  financial  field  the  development 
of  a  whole  series  of  specialized  courses:  money;  banking 
(or  money  and  banking) — meaning  by  banking,  as  a  rule,  only 
commercial  banking;  investments;  corporation  finance;  specu- 
lation; foreign  exchange;  bank  management,  etc.  It  was 
inevitable  that  there  should  be  much  duplication  of  material  in 
these  specialized  courses;  and  at  the  same  time  the  want  of  a 
common  background  of  training  on  the  part  of  the  students 
in  any  one  course  necessarily  militated  against  a  highly  critical 
analysis.  The  present  treatise  constitutes  an  attempt  to  bring 
together  within  a  single  volume,  and  in  a  single  course,  the 
material  that  is  necessary  as  a  background  to  advanced  study 
in  any  of  the  special  fields  of  financial  inquiry  suggested  in 
the  outline  of  courses  above.  It  is  believed  that  much  economy 
of  teaching  e£Fort  may  thus  be  achieved  and  that  at  the  same  time 
the  advanced  courses  may  be  lifted  to  a  substantially  higher 
plane  than  obtains  in  most  institutions  at  present.  The 
treatise  therefore  differs  from  the  traditional  volume  in  money 
and  banking,  in  that  it  is  more  inclusive  in  scope. 

The  attempt  to  organize  a  general  survey  course  in  the 
field  of  finance  has,  however,  not  only  resulted  in  combining 
in  a  single  volume  certain  material  that  is  common  to  all 
financial  courses;  it  has  also,  inevitably,  led  to  a  substantial 
shift  in  emphasis  and  in  the  point  of  view  from  which  the 
material  is  presented.  As  is  indicated  above,  and  as  is  more 
clearly  revealed  in  the  charts  to  which  reference  has  been  made, 
the  numerous  financial  institutions  which  make  up  the  modern 
financial  system  are  united  in  a  conmion  task  of  furnishing 
fixed  and  working  capital  for  business  enterprises,  the  various 
types  of  institutions  being  very  closely  interrelated  as  parts  of  a 
general  financial  structure.  I  may  frankly  say  that  I  did  not 
fully  appreciate  this  fact  until  I  undertook  to  describe  the 
practical  operations  of  each  of  the  numerous  types  of  financial 


xiv  AUTHOR'S  PREFACE 

institutions  that  exist  today,  and  to  point  out  the  economic 
significance  of  each.  The  very  attempt  to  explain  the  economic 
function  of  each  financial  institution  inevitably  carried  one  into 
a  discussion  of  its  relation  to  other  financial  institutions,  and 
thus  to  a  consideration  of  the  relation  of  the  financial  system  in 
general  to  the  economic  system  in  general.  A  more  complete 
statement  of  the  relationship  here  suggested,  as  well  as  an 
explanation  of  the  use  of  the  term  Financial  Organization  of 
Society,  will  be  found  in  the  introductory  chapter. 

Another  reason  for  making  the  introductory  course  in 
finance  a  general  survey  rather  than  a  discussion  merely  of 
money  and  of  commercial  banking  is  found  in  the  fact  that 
almost  every  financial  institution  in  the  United  States  now 
conducts  under  a  single  roof  and  under  the  direction  of  a  single 
management,  nearly  every  variety  of  financial  operation.  As  is 
indicated  in  the  chapter  on  "Financial  Integration,"  the 
department-store  financial  institution  has  become  the  prevailing 
type.  In  consequence,  it  is  difl&cult  to  justify  a  survey  course 
designed  to  acquaint  the  student  with  the  principles  of  finance, 
which  selects  for  discussion  only  a  single  function  performed 
by  any  banking  organization — such  as  commercial  banking — to 
the  exclusion  of  all  the  others.  This  is  particularly  the  case 
if  the  needs  of  the  business  student  be  held  in  mind.  The 
modem  business  has  its  setting  in  the  midst  of  a  financial 
system  upon  which  it  is  at  all  times  dependent  in  many  ways; 
and  the  business  man  needs  to  know  not  merely  the  relation 
of  his  business  to  the  commercial  banking  department  of, 
say,  the  First  National  Bank  of  New  York,  but  to  all  of  the 
other  departments  of  that  bank  as  well.  Moreover,  because 
of  the  close  interrelations  that  exist  between  the  departments 
of  an  integrated  financial  institution,  the  student  of  banking 
organization  and  theory  will  gain  a  very  inadequate  view  of 
modern  finance  if  he  studies  the  commercial  banking  department 
as  though  it  were  an  isolated  institution. 

In  colleges  where  but  a  single  course  can  be  devoted  to 
the  study  of  finance,  it  would  seem  that  a  course  which  pre- 
sents a  general  view  of  the  system  as  a  whole,  would  prove  both 


AUTHOR'S  PREFACE  xv 

of  more  practical  and  of  more  cultural  value  to  the  student 
than  one  which  considers  merely  certain  special  features  of 
the  financial  system. 

The  author  anticipates  no  Uttle  criticism  for  having  failed  to 
include  in  a  volume  on  finance  a  thorough  discussion  of  so 
important  and  vital  a  subject  as  the  relation  of  money  and 
credit  to  prices.  A  word  of  explanation  is  therefore  in  point. 
In  chapter  ii  there  is  presented  a  very  brief  statement  of  the 
relation  of  money  and  prices.  The  emphasis  is,  however,  not 
placed  upon  the  causes  of  price  changes;  it  is  merely  pointed 
out  that  the  values  of  goods  are  expressed  in  terms  of  money 
and  that  these  money  prices  fluctuate  widely  and  more  or  less 
continuously.  Now  the  reason  for  not  entering  into  a  dis- 
cussion of  the  causes  of  price  changes  at  that  place  is  merely 
that  the  price  question  cannot  be  intelligently  discussed  until 
an  analysis  of  the  commercial  banking  system  has  been  made; 
and  by  the  time  the  analysis  of  the  commercial  banking  system, 
including  its  relation  to  other  financial  institutions  and  to  the 
general  business  organization  as  conditioned  by  the  phenomena 
of  the  business  cycle,  was  completed,  limitations  of  space  did 
not  well  permit  an  adequate  discussion  of  this  most  vital  aspect 
of  the  modem  financial  system.  The  controversial  issues  with 
reference  to  the  relation  of  money  to  prices  are  therefore 
necessarily  left  for  consideration  in  advanced  courses.  It  is 
believed  that  enough  data  bearing  on  the  price  question  are 
presented  in  the  treatise  for  the  purposes  in  hand.  If,  in  the 
view  of  any  teacher,  such  is  not  the  case,  the  text  material 
may  be  readily  supplemented  by  lectures  and  by  collateral 
reading. 

In  the  preparation  of  the  volume  I  am  indebted  to  Mr. 
Walter  Buckingham  Smith,  of  the  Department  of  Political 
Economy  of  the  University  of  Chicago,  for  assistance  in  con- 
struction of  the  various  charts;  and  to  Messrs.  Hardy,  Keister, 
Marshall,  Meech,  Thompson,  Smith,  and  Viner,  of  the  same 
department,  for  many  helpful  criticisms,  as  well  as  for  assistance 
in  reading  the  manuscript.  I  am  also  indebted  to  Professor 
E.  G.  Nourse,  of  Iowa  State  College,  foj:  criticisms  of  the 


xvi  AUTHOR'S  PREFACE 

chapter  on  Agricultural  Credit.  But  most  of  all  I  think  I  am 
indebted  to  the  generations  of  suffering  students  who  have 
patiently  submitted  to  experimentation  as  the  volume  has 
slowly  evolved  through  mimeograph,  preprint,  and  preliminary 
editions  to  its  present  form. 

H.G.M. 

Chicago,  Illinois 

December  25,  1930 


TABLE  OF  CONTENTS 

PAGE 

Chapter  I.    Introduction 

Chapter  II.    The  Nature  and  Functions  of  a  Pecuniary 
Unit 

I.  Definition  and  Origin  of  the  Pecuniary  Unit  ...       4 
II.  The  Pecuniary  Unit  and  Business  Administration     .       6 

III.  The  Pecuniary  Unit  and  the  Apportionment  of  Family 
Expenditures 11 

IV.  The  Pecuniary  Unit  and  Economic  Organization       .     13 

Chapter  III.    The  Standard  for  Deferred  Payments 

I.  Why  Gold  Is  Used  as  the  Standard 19 

II.  Relation  of  Money  and  Prices 21 

III.  Economic  Consequences  of  Price  Changes       ...  23 

IV.  Price  Changes  and  Social  Maladjustments      ...  30 

Chapter  IV.    Other  Functions  and  Services  of  Money 

I.  Money  as  a  Medium  of  Exchange 41 

II.  Money  as  a  Store  of  Value 42 

III.  The  Use  of  Money  in  Production 43 

IV.  The  Role  of  Money  in  War  Finance 45 

V.  The  Role  of  Money  in  Peace  Finance 48 

Chapter  V.    The   Pecuniary  System  and   Economic   and 
Social  Standards 

I.  Monetary  Evaluation  and  Social  Ideals     ....     54 

II.  The  Confusion  of  Money  with  Wealth       ....     56 

III.  The  Quantity  of  Money  Required  by  a  Nation    .     .     60 

Chapter  VI.    The  Regulation  of  Metallic  Currency 

I.  The  Necessity  of  Government  Coinage      ....  65 

II.  Economic  and  Social  Effects  of  a  Bad  Coinage  System  67 

III.  Coinage  Rules  and  Regulations  of  the  United  States  .  69 

IV.  Gresham's  Law  and  Bimetallism 73 

V.  Why  Gold  Became  the  Single  Standard     ....  79 

VI.  Production  of  Gold  and  Silver  in  the  World  Since  the 
Discovery  of  America 82 

xvii 


xviii  CONTENTS 

FAGX 

VII.  Commercial  Ratio  of  Gold  and  Silver  Since  1687  83 

VIII.  The  Regulation  of  Subsidiary  Metallic  Currency       .     84 

DC.  Legal  Tender  Provisions  for  Metallic  Currency    .     .     85 

Chapter  VII.     The   Regulation   of    Government   Paper 
Currency 

I.  Irredeemable  Paper  or  Fiat  Currency 92 

II.  Arguments  for  and  against  Fiat  Paper  Currency       .     96 

III.  Methods  of  Regulating  Paper  Currency     ....     98 

IV.  Forms    of    Government    Paper    Ciirrency    in    the 
United  States 100 

V.  Redemption  of  United  States  Paper  Currency      .     .102 
VI.  Legal  Tender   Provisions  of  United   States  Paper 

Currency 102 

VII.  Estimated  General  Stock  of  Money  in  the  United 

States,  February  i,  1920 103 

Chapter  VIII.    The  Foreign  Exchanges 

I.  The  Nature  of  the  Problem 107 

II.  The  Exchange  Mechanism    ........  109 

III.  The  Maintenance  of  Equilibrium 114 

IV.  Domestic  Exchanges .     .     .115 

V.  Foreign  Exchange  during  the  War 116 

VI.  The  Post-War  Depreciation  of  the  European  Ex- 
changes       117 

Chapter  DC.    The  Nature  and  Functions  of  Credit 

1.  The  Nature  of  Credit 121 

II.  The  Various  Kinds  of  Credit 122 

in.  Investment,  Commercial,  and  Consumptive  Credit  .  124 

IV.  The  Basis  of  Credit 125 

V.  The  Significance  of  Credit 127 

Chapter  X.    The  Modern  Financial  Structure 

I.  Institutions   Utilized   in   Financing   Non-Corporate 

Enterprise 134 

II.  Institutions  Utilized  in  Financing  Corporate  Enter- 
prise       136 

Chapter  XI.    The  Corporation  as  a  Device  for  Raising 
Capital 

I.  Advantages  of  the  Corporation  in  Raising  Capital    .  140 
n.  Stages  of  Corporate  Development 143 


CONTENTS  XIX 

PAGE 

Chapter  XTE.    Credit  Instruments 

I.  Investment  Credit  Instruments 151 

II.  Commercial  Credit  Instruments 162 

III.  The  Use  of  Credit  Instruments  in  Transferring  Wealth  170 

Chapter  XIII.    The  Marketing  of  Low-Grade  Securities 

I.  The  Promotion  of  Fraudulent  and  Worthless  Securities  186 

II.  The  Sale  of  Highly  Speculative  Securities       .     .     .191 

III.  Blue  Sky  Legislation 197 

IV.  Suggested  Control  over  the  Formation  of  Corporations  205 

Chapter  XIV.    The  Marketing  of  High-Grade  Securities 

I.  History  of  Investment  Banking 212 

II.  Modem  Investment  Banking  Development     .     .     .  214 

III.  Functions  of  Investment  Banking  Institutions     .     .  217 

IV.  Investigation  and  Analysis 218 

V.  The  Underwriting  Function 228 

VI.  The  Distribution  Function 234 

Vn.  Sundry  Services  of  Investment  Bankers    ....   240 
VIII.  Capital   Requirements   and   Profits  of   Investment 

Banks 243 

IX.  The  Regulation  of  Investment  Banking     ....   245 
X.  Investment  Banks  and  the  General  Economic  Organi- 
zation    247 

Chapter  XV.    Foreign  Investment  Trusts 

I.  British  Investment  Trusts .  257 

II.  The  Shift  in  America's  Financial  Position       .     .     .  260 

III.  American  Investment  Trusts 263 

IV.  Future  of  American  Foreign  Investments  ....   269 

Chapter  XVI.    The  Stock  Exchange  and  Capital  Raising 

I.  History  of  Stock  Exchanges 279 

II.  The  Organization  of  Exchanges 281 

III.  The  Brokerage  Business 285 

IV.  Economic  Functions  of  the  Stock  Exchange    .     .     .  293 

Chapter  XVII.    Trust  Companies  and  the  Modern  Finan- 
cial System 

I.  The  Scope  of  Trust  Company  Operations       .     .     .  302 
n.  Services  Rendered  to  Individuals 304 

III.  Services  Performed  for  Estates 305 


XX  CONTENTS 

PAGE 

IV.  Trust  Companies  and  Corporation  Finance    .     .     .  306 

V.  The  Trust  Company  as  Custodian  of  Securities   .     .316 

VI.  The  Regulation  of  Trust  Companies 322 

Chapter  XVIII.    The  Functions  of  Savings  Institutions 

I.  Stock  Savings  Banks 327 

II.  Mutual  Savings  Banks 332 

III.  Savings  Departments  in  Commercial  Banks   .     .     .  334 

IV.  Postal  Savings  Banks .     •  335 

V.  The  Management  of  Savings  Institutions  ....  339 

VI.  The  Profits  of  Savings  Banks .  343 

VII.  Insurance  Companies  as  Savings  Institutions       .     .  344 
Vin.  The  Economic  Significance  of  Savings  Institutions  .  348 

Chapter  XIX.    The  Practical  Operations  of  the  Com- 
mercial Bank 

I.  Classification  of  Commercial  Banks 358 

n.  Incidental  Services  of  Commercial  Banks  .  .  .  .361 
HI.  Analysis  of  Commercial  Banking  Operations  .  .  .  363 
IV.  Analysis  of  Commercial  Bank  Loans 374 

Chapter  XX.    Commercial  Banking  and  the  Financing  of 
Foreign  Trade 

I.  Financing  Import  Trade 410 

n.  Financing  Export  Trade 418 

in.  The  Edge  Law  and  the  Financing  of  Foreign  Trade     422 
IV.  Conclusion 423 

Chapter  XXI.    Commercial  Paper  Houses  and  Discount 
Companies 

A.  Commercial  Paper  Houses 427 

I.  Practical  Operations 428 

H.  The    Economic   Significance  of  Commercial  Paper 

Houses 435 

B.  Discount  Companies 437 

I.  Purchasing  Accounts  Receivable 438 

n.  The  Financing  of  Automobile  Distribution    .     .     .  443 

Chapter  XXII.    The  Commercial  Banking  System 

I.  Clearing-House  Associations      . 457 

II.  Relations  between  Banks  in  Different  Cities  .  ,  .  470 
HI.  Loans,  Deposits,  and  Reserves 475 


CONTENTS  xxi 

PAOX 

IV.  Commercial   Banking   and   the   Supply  of   Liquid 

Capital  or  Currency 483 

V.  Commercial   Banking  and  the   General   Economic 
Organization 486 

Chapter  XXIII.    Coiimercial  Banking  and  the  Ebb  and 
Flow  of  Business 

I.  Seasonal  Variations  in  the  Demand  for  Funds     .     .  495 

II.  Cyclical  Variations  in  the  Demand  for  Funds      .     .  505 

III.  Commercial  Banking  and  Business  Cycles      .     ,     .   519 

Chapter  XXIV.    Government  Regulation  of  Banking 

I.  Summary  of  American  Banking  History    ....  547 
II.  Principles  of  Governmental  Regulation      ....  550 

III.  The  Regulation  of  State  Banking    .     .     .     .     .     .559 

IV.  The  Regidation  of  Bank  Notes 562 

Chapter  XXV.    The  Federal  Reserve  System 

I.  The  History  of  Banking  Reform 566 

II.  Administrative  Framework  of  the  System       .     .     .  574 

III.  Provision  of  an  Elastic  Bank-Note  Currency  .     .   .  577 

IV.  The  Control  of  Credit 589 

V.  The  Creation  of  a  "Discount  Market"      ....  600 

VL.  Clearings  and  Collections 608 

VII.  Relation  of  the  Treasury  to  the  Federal  Reserve 

System 614 

VIII.  Federal  Reserve  Bank  Statements 616 

Chapter  XXVI.    The  War  and  the   Federal  Reserve 
.   System 

I.  Eflect  of  War  Finance  upon  Bank  Reser\'es    .     .     .  627 
n.  The  Movement  of  Reserves  after  the  War      .     .     .632 
in.  The  Attempt  to  Control  Credit  and  Business  Expan- 
sion        634 

Chapter  XXVII.    Raising  Capital  for  Agriculture 

A.  Working  Capital 653 

I.  Trade  Credit 654 

II.  Commercial  Bank  Loans  for  Agricultiu"e      .     .     .  656 
III.  The  Work  of  the  Cattle  Loan  Company      .     .     .  659 

B.  Fixed  Capital 665 

I.  The  Nature  and  Extent  of  the  Farm  Mortgage 
Business        665 


Xxii  CONTENTS 

PAGK 

n.  Institutions  Utilized  in  Marketing  Farm  Mortgages  667 

III.  The  Federal  Farm  Loan  System 672 

IV.  Significant   Results   of   the   Federal   Farm  Loan 
System 686 

V.  Criticisms  of  the  Federal  Farm  Loan  System    .     .  688 

Chapter  XXVIII.    Consumptive  Credit  Institutions 

I.  The  Business  of  Pawnbroking 699 

II.  The  Loan  Sharks 703 

m.  The  Morris  Plan  Bank 708 

IV.  Co-operative  Credit  Unions       .......  708 

V.  Building  and  Loan  Associations 714 

Chapter  XXIX.    Financial  Integration 

I.  Causes  of  the  Growth  of  Financial  Integration    .     .725 

II.  Possible  Dangers  of  Department-Store  Banking  .     .  732 

HE.  The  Unification  of  the  Banking  System     ....  733 

Chapter  XXX.    The  Financial  System  and  the  General 
Economic  Organization 
I.  Merits  and  Defects  of  the  Pecuniary  Mechanism      .   743 
II.  The  Role  of  Finance  in  Modem  Economic  Organiza- 
tion        748 

III.  The  Dominant  Position  of  the  Finahcier   ....   750 

IV.  International  Aspects  of  Financial  Organization  .     .754 

V.  The  Concentration  of  Financial  Power      ....   756 
VI.  Financial  Power  and  the  Control  of  Undeveloped 

Regions 772 


LIST  OF  ILLUSTRATIONS 

PAGE 

Chart:    Level  of  Prices  from  1840  to  1920       .     .     .     .     31 
Chart:    I.    Institutions   Utilized  in  Financing  Non- 
Corporate  Enterprise 134 

Chart:    II.  Institutions  Utilized  in  Financing  Corporate 

Enterprise 136 

Chart:    The  Investment  Banking  Structure     .     .     .     .218 

Chart:    Determination  of  Bond  Values 222 

Chart:  The  Gold  Holdings  of  the  Leading  Nations  .  .271 
Chart:    Growth  and  Importance  of  Commercial  Banks  and 

Trust  Companies 359-360 

Chart:  Money  Rates  in  New  York  City  .  .  .  .  .  393 
Chart:  Principal  Items  in  National  Bank  Statements  479 
Chart:    Reserves  and  Ratios  of  Reserves  to  Deposits  of 

New  York  City  Clearing-House  Banks,  i  890-1 908  498 
Chart:    Seasonal  Variations  of  Various  Kinds  of  Money 

AND  OF  Deposits  in  the  United  States,  i  890-1 908  .  499 
Chart:  World  Movement  of  Prices,  1914-1920  .  .  .  626 
Chart:    Institutions  Utilized  in  Agricultural  Borrowing  650 

Map:   Federal  Reserve  Districts 573 

Map:   The  Federal  Farm  Loan  Districts 676 

First  Mortgage  Bond 158-59 

Share  of  Cumulative  Preferred  Stock 160-61 

Promissory  Note '.     .  163 

Trade  Acceptance 165 

Bank  Acceptance 166 

Bankers'  Bill  of  Exchange  on  London 167 

Cashier's  Check 167 

Personal  Bank  Check 167 

Borrower's  Statement — Corporation 381 

Collateral  Note  and  Agreement 387 

Bill  of  Lading 398 

Warehouse  Receipt 400 

Trust  Receipt 415 

Letter  of  Credit  Agreement     ,     ,     .     , 416 

Import  Letter  of  Credit 417 

Chattel  Mortgage 445 

Conditional  Sale  Agreement 447 

Lease  Agreement 45^ 

zziu 


CHAPTER  I 

INTRODUCTION 

The  term  "financial  organization  of  society"  is  intended  to 
indicate  the  dependency  of  modern  industrial  society  upon  finan- 
cial institutions.  It  is  hardly  too  much  to  say  that  the  entire 
process  of  wealth  production  and  distribution  is  organized  on  the 
basis  of  a  monetary  unit  of  calculation,  called  in  the  United 
States  the  "dollar,"  and  worked  out  through  the  use  of  financial 
instnunents  and  agencies.  The  assembling  of  land,  labor,  and 
capital,  and  their  organization  into  a  productive  business,  is 
accomplished  through  the  use  of  money  and  credit;  the  market- 
ing of  the  products  of  such  industry  is  carried  out  through 
financial  means;  and  the  division  of  the  rewards  of  the  enter- 
prise in  the  form  of  rent,  wages,  interest,  and  profits  is  effected 
in  financial  terms  and  by  financial  instruments. 

In  a  broader  way,  the  distribution  of  our  social  energy 
among  the  various  forms  of  productive  activities  in  the  world 
of  industry  is  determined  by  financial  considerations  which 
manifest  themselves  through  the  mechanism  of  prices  and 
profits.  And  the  flow  of  labor  and  capital  over  the  earth,  from 
country  to  country  and  from  region  to  region,  is  largely  guided 
and  controlled  by  considerations  which  find  their  expression  in 
financial  terms. 

Stated  in  specific  terms,  the  financial  organization  of  society 
involves  a  study  of  the  part  that  money,  in  its  various  roles, 
plays  in  the  organization  of  industrial  activities;  of  the  regu- 
lation of  the  monetary  unit  and  of  the  various  forms  of  sub- 
sidiary currency;  and  of  the  relationship  of  the  pecuniary 
system  to  the  pressing  problems  of  social  weU-being.  Since 
modern  industry  is  largely  conducted  on  the  basis  of  borrowed 
funds,  the  entire  credit  mechanism  is  involved.  This  treatise 
therefore  includes  an  analysis  of  the  process  of  raising  funds 


2  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

for  fixed  capital,  i.e.,  plant  and  equipment,  and  for  working, 
or  operating,  capital,  through  the  use  of  investment  and  com- 
mercial credit  instruments  in  the  form  of  stock  and  bonds,  and 
bills  of  exchange  and  promissory  notes,  respectively,  and  the 
problems  associated  therewith.  The  corporation,  as  the  pre- 
vailing form  of  business  organization,  is  considered  in  its  aspect 
as  a  financial  institution,  designed  to  faciUtate  the  raising  of 
capital;  and  much  of  the  discussion  is  devoted  to  an  analysis 
of  the  services  rendered  by  the  numerous  types  of  financial 
institutions  that  have  been  developed  in  connection  with  the 
marketing  of  corporate  securities — ^underwriting  syndicates, 
distributing  bond  houses,  savings  banks,  insurance  companies, 
commercial  banks,  brokerage  concerns,  the  stock  exchange,  etc. 
The  treatise  also  naturally  includes  a  study  of  the  financing  of 
agricultural  business  and  the  market  mechanism  that  this 
has  required;  as  also  private  borrowing  for  non-business  pur- 
poses and  the  organization  of  co-operative  loan  associations. 

Of  predominant  importance  in  the  entire  financial  mechan- 
ism is  the  commercial  banking  system.  This  is  discussed  in 
relation  to  the  fiumshing  of  funds  for  fixed  capital,  both  by  the 
outright  purchase  of  securities  and  by  advances  of  funds  to 
investment  bankers  and  to  stock  exchange  "margin"  operators, 
as  well  as  in  relation  to  the  furnishing  of  working  capital  to  pro- 
ducing, manufacturing,  and  mercantile  establishments.  The 
regulation  of  commercial  banking,  the  weaknesses  that  developed 
in  practice  under  the  national  banking  system,  particularly  in 
connection  with  the  ebb  and  flow  of  business  activities  at  differ- 
ent seasons  of  the  year  and  at  different  periods  of  the  business 
cycle,  are  set  forth  as  a  background  for  a  study  of  the  Federal 
Reserve  System  and  the  machinery  that  has  been  devised 
thereunder  for  the  more  efficient  adjustment  of  finance  to  the 
varying  requirements  of  business. 

If  the  reader  will  turn  to  the  charts  on  pages  134,  136  and 
650,  he  will  be  afforded  a  general  view  of  the  various  financial 
institutions  which  enable  the  business  operators  of  the  modern 
industrial  system  to  raise  the  funds  required  for  the  conduct  of 
Dartnership,  corporate,  and  agricultural  industry,  respectively. 


INTRODUCTION  3 

A  Study  of  the  financial  organization  of  society  should 
clearly  reveal  the  economic  functions  performed  by  the  various 
types  of  financial  agencies  that  have  been  developed.  And  it 
should  inquire  whether  these  agencies  on  the  whole  promote 
an  efficient  and  well-balanced  national  life.  It  should  disclose 
such  weaknesses  as  have  developed  from  time  to  time  in  the 
financial  mechanism  and  indicate  how  and  to  what  extent  these 
have  been  eUminated  through  private  and  government  regula- 
tion. It  should  also  be  the  purpose  to  ascertain  what  defects 
in  the  financial  organization  of  society  still  persist  and,  where 
possible,  to  point  the  way  to  their  elimination. 

It  is  apparent  that,  thus  conceived,  a  study  of  the  financial 
organization  of  society  is  of  very  broad  scope.  The  many  types 
of  financial  institutions  and  instrumentalities  which  function  in 
the  modem  industrial  system  are,  moreover,  not  to  be  regarded 
merely  as  isolated  economic  agencies.  They  constitute  an 
intricate  financial  structure  that  is  closely  interwoven  with  the 
entire  economic  organization  by  means  of  which  the  wants  of 
the  world  are  supplied. 


CHAPTER  n 

THE  NATURE  AND  FUNCTIONS  OF  A 
PECUNIARY  UNIT 

The  complex  social  and  industrial  system  of  the  present  day 
is  commonly  said  to  be  organized  on  the  basis  of  a  pecuniary 
unit  of  calculation  called,  according  to  the  country,  the  dollar, 
pound  sterling,  franc,  mark,  ruble,  etc.  In  this  chapter  it 
is  our  purpose  to  consider  the  precise  nature  of  the  monetary 
unit  and  to  disclose  the  various  ways  in  which  it  is  of  service 
to  society.  It  will  help  to  avert  misunderstanding  on  the  part 
of  the  reader  if  it  is  stated  at  the  outset  that  the  function  of  a 
pecuniary  unit  of  calculation  is  quite  diflFerent  from  that  of  a 
medium  of  exchange,  discussion  of  which  is  reserved  for  the 
fourth  chapter. 

I.    DEFINITION  AND  ORIGIN  OF  THE 
PECUNIARY  UNIT 

The  significance  of  the  monetary  unit  may  best  be  appre- 
ciated if  it  is  thought  of  as  a  certain  definite  weight  and  fineness 
of  metal.  For  instance,  the  unit  in  the  United  States  (the  gold 
dollar)  is  composed  of  25 .8  grains  of  metal,  of  which  nine-tenths 
is  gold  and  one-tenth  copper  alloy.  How  this  particular  amount 
of  metal  came  to  be  chosen  as  the  unit  need  not  be  considered 
here.  It  is  sufficient  for  our  present  purposes  to  know  that  Con- 
gress is  not  much  more  likely  to  change  the  weight  and  fineness 
of  the  dollar  than  to  change  other  imits  of  measurement,  such  as 
the  pound,  foot,  gallon,  etc.  It  may  also  be  noted  in  passing 
that  this  monetary  unit  does  not  necessarily  circulate  in  the 
form  of  currency;  indeed,  it  need  not  be  coined  at  all.  The 
American  gold  dollar,  for  example,  is  not  coined  because  it 
would  be  too  small  for  convenience  in  the  channels  of  circulation. 

The  pecuniary  unit  is  a  sort  of  language  device.  To  under- 
stand the  functions  of  this  pecuniary,  or  calculating,  unit,  it  will 


NATURE  AND  FUNCTIONS  OF  A  PECUNIARY  UNIT    5 

be  well  to  regard  it  as  a  sort  of  language  device,  a  final  step,  as 
it  were,  in  the  development  of  means  of  communicating  ideas. 
Because  of  restricted  vocabulary  primitive  man  found  great 
difficulty  in  exchanging  ideas  with  his  fellows,  with  a  result  that 
both  intellectual  and  material  progress  were  seriously  retarded. 
Trading  operations  were  early  impeded,  moreover,  not  only 
because  of  inadequate  word  symbols  for  the  communication  of 
ideas,  but  also  because  of  the  lack  of  numerical  symbols  for 
reckoning  quantities.  It  was  necessary  for  a  system  of  notation 
to  be  developed  before  trading  could  be  conducted  on  any  con- 
siderable scale;  for  it  is  apparent  that  without  a  means  of 
quantitative  measurement  of  the  goods  to  be  purchased  or  sold, 
the  risk  involved  in  trading  operations  would  be  so  great  as  to 
prevent  all  except  the  simplest  transactions. 

But  the  development  of  a  system  of  notation  was  not  suffi- 
cient of  itself  to  lay  the  basis  for  extensive  trading  operations. 
A  still  further  step  in  the  development  of  the  language  of 
trade  and  business  was  necessary,  namely,  that  of  expressing 
a  variety  of  quantitative  units  in  terms  of  some  qualitative,  or 
value,  unit.  It  is  very  difficult  to  trade  yards  of  cloth  for  tons  of 
coal,  or  bushels  of  wheat  for  skins  of  animals,  without  some 
means  of  reckoning  the  relative  values  of  physical  quantities  of 
unlike  goods. 

It  is  probable  that  the  use  of  money  as  a  pecuniary  unit,  in 
terms  of  which  the  values  of  unlike  quantities  are  measured, 
developed  earlier  than  its  use  as  a  medium  of  exchange.  The 
word  "pecuniary"  comes  from  the  Latin  word  for  money, 
pecunia,  and  it  is  generally  allowed  that  pecunia  is  derived  from 
pecus,  meaning  cattle.  Now  cattle  were  probably  not  used  as 
media  of  exchange;  one  would  suppose,  rather,  that  since  their 
approximate  value  was  a  matter  of  common  knowledge  during 
the  pastoral  stage  of  economic  development,  cattle  served  merely 
as  a  means  of  measuring  values.''    Among  barbaric   tribes 

» "But  now  Zeus,  son  of  Kronos,  took  from  Glaucus  his  wits,  in  that  he 
made  exchange  with  Diomedes,  Tydeus'  son,  of  golden  armor  for  bronze, 
the  price  of  fivescore  oxen  for  the  price  of  nine." — Iliad,  Book  vi,  118, 
Lang,  Leaf  and  Meyers'  translation. 


6  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

wealth  has  often  been  expressed  in  terms  of  shells,  precious 
stones,  skins,  or  whatever  commodity  was  most  widely  known. 
Wherever  they  were  found  in  sufficient  quantity  the  precious 
metals,  gold  and  silver,  naturally  came  to  be  used  for  the  same 
purpose.  But  gold  and  silver,  shells,  etc.,  unlike  cattle,  were 
also  serviceable  as  media  for  effecting  actual  exchanges  of  goods. 
It  would  seem  that  the  use  of  money  as  a  medium  of  exchange 
was  necessarily  of  later  development  than  its  use  as  a  common 
denominator  of  values;  for  it  is  difficult  to  conceive  of  an 
exchange  of  goods  for  money  where  there  had  not  already  been  a 
pre-existing  evaluation  of  the  goods  in  terms  of  a  pecuniary  unit. 
In  any  event,  the  development  of  a  pecuniary  unit  gave  the 
necessary  commensurability  to  pounds,  quarts,  and  bushels — 
and  to  wheat,  cattle,  and  cloth — and  was  thus  one  of  the  most 
significant  developments  in  history.  It  was  the  final  vital 
step  in  the  evolution  of  means  of  communicating  ideas.  It  made 
language  and  numbers  inteUigible  for  the  purposes  of  business. 

n.    THE  PECUNIARY  UNIT  AND  BUSINESS 
ADMINISTRATION 

We  have  been  saying  that  without  a  unit  for  measuring 
values  exchange  operations  are  very  difficult  and  involve  large 
risks.  We  shall  now  see  that  a  pecuniary  unit  is  of  the  greatest 
importance  from  the  standpoint  of  efficient  production.  Let  us 
take  a  simple  case  and  endeavor  to  ascertain  the  difficulties 
that  would  arise  in  the  conduct  of  a  business  in  the  absence  of  a 
pecuniary  unit  such  as  the  dollar. 

Mr.  X  is  a  manufacturer.  He  finds  that  he  has  10,000  yards 
of  finished  cloth  on  hand,  12,000  pounds  of  raw  cotton  in  his 
warehouse,  and  5,000  yards  of  cloth  in  process  of  manufacture. 
He  has  supplies  in  his  shop,  consisting  of  so  many  gallons  of  oil, 
rolls  of  packing,  etc.  He  has  a  building  that  is  100  feet  long 
and  60  feet  wide,  with  two  stories,  each  14  feet  high.  The 
building  is  made  of  reinforced  concrete  material.  His  power 
and  heating  plant  is  five  years  of  age,  with  five  years  of  wear 
remaining.  He  owns  two  delivery  wagons  and  four  horses,  all 
somewhat  the  worse  for  wear  and  tear.    He   manufactures 


NATURE  AND  FUNCTIONS  OF  A  PECUNIARY  UNIT    7 

50,000  yards  of  cloth  per  year,  of  which  30,000  yards  are  of  grade 
A,  10,000  yards  of  grade  B,  and  10,000  yards  of  grade  C.  With- 
out a  means  of  measuring  all  these  units  in  terms  of  a  common 
denominator  of  value,  it  is  apparent  that  it  would  be  impossible 
for  Mr.  X  to  ascertain  from  his  books  whether  his  business  is 
successful  or  unsuccessful.  It  is  also  obvious  that  the  chances  of 
failure  would  be  very  great. 

The  choice  of  a  business  is  determined  by  analysis  of  pecuniary 
accounts.  Let  us  now  inquire  how  Mr.  X  came  to  choose  this 
particular  line  of  business.  Having  capital  at  his  disposal,  he 
naturally  would  wish  to  employ  it  in  that  line  of  industry  which 
would  yield  him  the  largest  income.  Let  us  assume  that  at  the 
period  when  Mr.  X  must  decide  where  to  invest,  the  typical 
estabUshment  is  receiving  a  return  of  5  per  cent  on  the  capital 
invested  in  Hne  A;  10  per  cent  in  line  B;  15  per  cent  in  line  C; 
and  20  per  cent  in  line  D.  If  other  things  were  equal,  Mr.  X 
would  as  a  matter  of  course  choose  line  D,  But  other  things 
are  not  usually  exactly  equal.  There  may  be  more  risk  involved 
in  line  D,  and  hence  a  greatft  chance  of  failure  in  the  event  of 
untoward  developments.  It  may  well  be,  however,  that  the 
risks  in  line  D  are  not  proportionately  greater  in  line  A  and 
Une  B.  The  demand  for  the  produce  of  line  A  may  have  been 
decHning,  or  perhaps  D  is  at  present  enjoying  an  extraordinary 
demand.  In  either  event,  a  larger  margin  of  profit  can  for  the 
time  be  secured  in  line  D  than  in  line  A.  Since  Mr.  X  is  looking 
for  employment  of  his  funds  in  the  most  profitable  branch  of 
industry,  he  will  therefore  be  likely  to  choose  line  D,  providing 
of  course  there  are  no  personal  reasons  which  might  prevent  his 
success  in  that  line. 

The  question  now  arises,  how  can  the  business  man  ascertain 
the  rate  of  profits  in  different  industries  ?  In  brief,  by  a  study 
of  the  general  market  conditions  in  the  different  industries  and  of 
the  financial  returns  actually  received  by  existing  plants  in  the 
various  lines  of  industry.  The  quotations  of  securities  on  the 
stock  exchange  serve,  as  we  shall  later  see,  as  a  fairly  reliable 
index  to  the  relative  profits  of  different  industries.  In  case, 
however,  one  is  thinking  of  venturing  as  a  pioneer  into  a  new 


8  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

line  of  industry,  he  can  of  course  rely  only  upon  a  study  of 
general  market  conditions.  But  in  any  case  the  estimated 
relative  costs  of  production  in  this  and  other  lines  will  serve  as 
an  important  index  to  the  probabilities  of  success. 

It  should  be  noted  at  this  point  that  the  decision  of  the 
business  man  is  more  or  less  controlled  by  financiers  who  advance 
the  funds  required  to  finance  the  industry.  The  typical  business 
is  nowadays  organized  on  a  corporate  basis,  and  the  fixed 
capital  is  largely  raised  by  the  sale  of  bonds  and  stock  through 
the  intermediation  of  investment  bankers,  whose  support  is 
necessary  tc  the  success  of  the  enterprise.  Investors  also  study, 
with  the  aid  of  pecuniary  accounts,  the  prospective  value  of  the 
securities,  and  since  investors  hold  the  purse  strings,  they 
have  the  power  to  veto  the  judgment  of  both  the  financiers  and 
the  corporate  managers.* 

After  the  fixed  capital  has  been  raised  and  the  plant  con- 
structed and  equipped,  it  is  usually  necessary  to  borrow  some  of 
the  working  capital  required  to  operate  the  business.  Financial 
aid  must  now  be  sought  from  commercial  banks;  and  the  com- 
mercial banker  thus  in  turn  passes  judgment  on  the  feasibility 
of  the  enterprise.  And  once  more  the  financial  standing  of 
the  business,  as  shown  by  accounts  that  are  expressed  in 
pecuniary  terms,  affords  the  criterion  for  reliable  judgment. 

Managerial  decisions  are  rendered  on  the  basis  of  pecuniary 
data.  In  connection  with  the  construction  of  the  plant,  there 
are  numerous  decisions  which  must  be  rendered.  In  the  build- 
ing of  the  manufacturing  establishment  there  is,  for  instance,  a 
question  of  the  types  of  materials  to  be  used  in  the  construction. 
Shall  it  be  of  wood,  of  steel,  or  of  concrete  ?  The  cost  of  each, 
the  varying  rates  of  fire  insurance  with  the  respective  types  of 
materials,  the  relative  durability  for  the  purposes  in  hand  of  the 
different  materials,  all  must  be  taken  into  consideration.  And 
in  every  case  the  decision  re^'olves  around  the  question  of 
costs,  computed  in  terms  of  dollars. 

Similarly  in  equipping  the  establishment,  there  is  the  choice 
between  machine  A  and  machine  B.     Machine  A  costs  $i,ooo, 

'  See  chaps,  xiii  and  xiv  below. 


NATURE  AND  FUNCTIONS  OF  A  PECUNIARY  UNIT        9 

machine  B  costs  $i,2(X).  Machine  A,  however,  would  turn 
out  only  three-quarters  as  much  product  as  machine  B.  On  the 
other  hand,  machine  A  would  require  $50  more  per  year  for 
maintenance;  while  machine  B  would  last  five  years  longer. 
The  problem  of  deciding  which  type  of  machine  to  use  under 
these  conditions  is  not  a  simple  one  at  best.  But  it  is  much 
simpler  by  virtue  of  the  dollars  and  cents  computation  that  is 
possible  than  it  would  be  in  the  absence  of  any  such  guide. 

Let  us  suppose  that  the  decision  is  for  the  purchase  of 
machine  B.  Two  years  later  a  new  machine  is  put  upon  the 
market,  which  can  perform  the  same  work  at  one-half  the 
cost  per  unit  of  product.  Machine  B  has,  however,  ten  years  of 
wear  remaining  in  it.  Should  it  be  discarded  now  as  obsolete, 
or  should  it  be  used  until  worn  out  ?  There  is  here  involved  a 
delicate  balancing  of  costs;  and  a  decision  necessarily  carries 
with  it  a  certain  element  of  risk.  But  again  it  is  clear  that  the 
pecimiary  basis  of  reckoning  greatly  lessens  the  chances  of 
error  and  thereby  increases  the  probability  of  business  success. 

This  factory  employs  a  large  number  of  laborers.  The 
management  finds  that  there  is  a  possibility  of  a  considerable 
substitution  of  machinery  for  labor.  The  question  arises. 
When  is  it  wise  to  substitute  machinery  for  labor,  or  vice  versa, 
as  the  case  may  be?  The  decision  is  made,  as  in  the  other 
cases,  on  the  basis  of  pecuniary  calculations. 

Or  it  may  be  that  the  question  is  not  one  of  machinery 
versus  labor,  but  one  of  methods.  Shall  a  new  system  of  ofiice 
management  be  installed?  Shall  trained  technical  men  be 
employed  to  work  out  new  processes  in  the  various  parts  of  the 
industry  ?  The  business  man  attempts  to  compare  the  costs  of 
such  technological  aids  with  the  returns  from  the  improvements 
that  accrue.  There  is  again  some  risk  of  loss  involved,  but  by 
and  large  the  cost  computation  points  the  certain  way  to 
improvements  in  methods  and  efficiency. 

Instances  of  this  sort  might  be  multiplied  indefinitely. 
In  fact,  virtually  every  decision  that  is  made  by  the  business 
manager  today  involves  a  careful  consideration  of  costs  and 
returns;  practically  all  of  modem  business  is  organized  on  the 


lO  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

basis  of  pecuniary  computations.  The  enormous  size  of  the 
business  unit  nowadays,  together  with  the  complex  relationships 
that  obtain  between  the  business  man  and  those  from  whom  he 
buys  his  materials,  on  the  one  hand,  and,  on  the  other,  those 
to  whom  he  sells,  requires  not  merely  the  keeping  of  records  of 
transactions  that  are  entered  into;  it  necessitates  the  develop- 
ment of  elaborate  financial  accounting  systems  from  which 
cost  and  profit  data  may  be  obtained.  It  should  be  repeated 
here  that  witliout  the  monetary  unit  accounting  records  would 
be  Ufeless;  while  with  the  dollar  unit  the  business  man  may  use 
his  accoimts  both  as  an  indication  of  past  business  achievement 
and  as  a  guide  to  future  courses  of  action. 

In  the  preceding  paragraphs  we  have  been  considering  the 
relation  of  the  monetary  unit  to  the  problems  that  arise  in 
connection  with  the  administration  of  any  given  business.  Let 
us  now  assume  that,  owing  to  the  stress  of  competition  or  to  a 
declining  demand  for  the  products  of  a  given  industry,  the 
manager  decides  that  he  should  leave  this  industry  and  go  into 
something  else. 

The  manager  is  now  confronted  with  the  task  of  making  the 
transfer  with  a  minimum  of  loss.  It  should  be  borne  in  mind 
that  since  the  industry  as  a  whole  is  in  a  declining  state,  the 
establishment  cannot  readily  be  sold  to  someone  else.  He  must 
either  (a)  convert  an  estabUshment  that  manufactures  com- 
modity X  into  an  establishment  that  manufactures  commodity 
Y,  or  (b)  completely  dismantle  the  existing  establishment  and 
erect  an  entirely  new  plant,  adapted  to  the  production  of 
commodity  Y.  In  case  he  is  forced  to  choose  the  latter  alterna- 
tive the  problem  arises,  should  the  plant  be  dismantled  at  once 
and,  the  large  amount  of  fixed  capital  in  the  form  of  building 
and  equipment  be  scrapped  at  a  heavy  loss,  or  should  it  con- 
tinue to  be  used  in  this  line  of  production  until  worn  out  ?  In 
the  latter  event  the  yearly  profits  would  be  set  aside  with  a 
view  to  the  subsequent  erection  of  a  plant  for  the  manufacture 
of  commodity  Y.  With  this  problem  before  him,  the  business 
man  must  compare  the  losses  involved  in  scrapping  his  present 
fixed  capital  with  the  added  profits  that  might  be  gained  from 


NATURE  AND  FUNCTIONS  OF  A  PECUNIARY  UNIT       1 1 

an  earlier  development  of  the  plant  for  the  manufacture  of 
commodity  Y.  Relative  costs  expressed  in  terms  of  the  dollar 
unit  again  serve  as  the  guide  to  action;  although,  as  before,  such 
guidance  does  not  enable  the  decision  to  be  rendered  with 
absolute  precision. 

In  case  the  plant  is  of  such  a  nature  that  it  does  not  require 
complete  dismantling,  if  it  is  one  which  can  be  rehabilitated  for 
the  purpose,  the  process  of  shifting  industrial  production  is 
somewhat  simpler,  though  it  still  involves  questions  of  technical 
engineering,  construction,  and  administration.  As  before,  how- 
ever, the  decision  concerning  the  best  method  of  making  the 
necessary  changes  and  the  rapidity  with  which  they  should  be 
accomplished  rest  on  cost  computations  expressed  in  terms 
of  money. 

III.    THE  PECUNIARY  UNIT  AND  THE  APPORTION- 
MENT OF  FAMILY  EXPENDITURES 

Not  only  does  the  pecuniary  unit  He  at  the  basis  of  business 
organization;  it  is  also  the  basis  for  an  intelligent  apportion- 
ment of  income.  When  family  incomes,  which  in  a  pecuniary 
society  are  initially  received  in  the  form  of  money  rather  than 
in  the  form  of  goods,  are  carefully  considered,  a  formal  budget  is 
prepared  by  means  of  which  the  income  is  apportioned  in  such 
a  way  as  to  bring  the  largest  satisfaction  of  family  wants. 

Let  us  assume,  first,  a  family  income  of  $150  per  month, 
an  income  sufficient  to  buy  only  the  ordinary  necessities  of  Ufe. 
This  $150  must  provide  for  food,  clothing,  shelter,  Hght,  heat, 
and  miscellaneous  expenses.  Since  this  income  should  be  so 
apportioned  among  these  various  needs  that  the  family  will  enjoy 
the  largest  measure  of  comfort,  the  expenditure  in  each  direction 
must  be  considered  in  comparison  with  the  expenditures  in  every 
other  direction.  Will  $50  for  rent  and  $100  for  the  remaining 
necessities  give  as  large  a  measure  of  satisfaction  as  $25  for 
rent  and  $125  for  the  remaining  items  ?  Should  $75  be  spent  for 
food  and  $20  for  clothing,  or  should  it  be  $85  for  food  and  $10 
for  clothing?  The  arrangement  of  a  family  budget  in  this 
fashion  is  difficult  enough  at  best  and  precision  in  measurement 


12  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

is  of  course  not  to  be  expected.  The  dollar  unit,  however, 
provides  a  rough  measuring  stick  by  means  of  which  a  larger 
satisfaction  may  be  derived  from  a  given  income  than  would 
otherwise  be  possible. 

With  an  income  of  $i,ooo  a  month  the  problem  of  family 
expenditures  is  in  some  ways  less  difficult,  because  the  adequacy 
of  the  income  to  meet  the  bare  necessities  of  life  is  no  longer  in 
question.  From  another  standpoint,  however,  it  is  more  diffi- 
cult, because  a  wider  range  of  expenditures  for  luxuries  is  now 
possible.  After  necessities  are  provided  for,  how  shall  the 
remainder  be  spent  ?  Shall  it  be  for  a  new  chair,  a  picture,  or 
other  household  decoration  ?  Shall  it  be  for  more  extravagant 
clothes,  for  a  pleasure  trip,  or  for  a  new  automobile?  The 
family  would  no  doubt  prefer  to  enjoy  all  these  luxuries  rather 
than  to  choose  between  them ;  but  if  the  income  is  not  adequate 
to  provide  for  all  of  them,  the  question  of  selection  inevitably 
presents  itself.  The  cost  of  the  automobile  must  then  be  com- 
pared with  the  cost  of  a  pleasure  trip,  and,  in  fact,  with  all  the 
additional  things  that  might  be  purchased  if  the  automobile 
were  foregone.  The  dollar  unit  comes  to  stand  for  a  certain 
amoimt  of  "generalized  purchasing  power"  and  the  task  of 
making  a  wise  apportionment  of  the  family  income  is  thus 
greatly  simplified. 

The  monetary  unit  is  a  guide  to  savings  requirements.  Every 
family  also  has  the  problem  of  making  provision  for  the  pro- 
verbial rainy  day,  for  old  age,  and  for  dependents.  By  reckoning 
in  terms  of  dollars,  one  may  compute  with  a  fair  degree  of  accu- 
racy how  large  a  fund  of  savings  is  necessary  to  provide,  upon 
retirement,  an  income  sufficient  to  insure  himself  and  depend- 
ents from  want.  Let  us  assume  that  in  a  given  case  this  is 
$3,000  a  year.  To  make  sure  of  a  perpetual  income  of  $3,000 
a  year  it  is  therefore  necessary  to  accumulate,  assuming  the 
interest  rate  to  be  5  per  cent,  a  fund  of  $60,000.  In  order  to 
provide  this  fund  of  $60,000,  one  must  save  each  year  such 
proportion  of  his  income  as  will  eventuate  in  a  given  period 
of  time  into  a  fund  of  $60,000.  There  are  of  course  many 
exigencies  that  may  arise  to  prevent  one's  working  this  out  with 


NATURE  AND  FUNCTIONS  OF  A  PECUNIARY  UNIT       13 

precision.  The  monetary  unit,  however,  serves  at  least  as  a 
valuable  guide  to  one's  requirements.  Indeed,  insurance  tables 
worked  out  on  the  basis  of  the  dollar  unit  serve  as  a  very  reliable 
guide  to  the  saving  that  is  necessary  in  given  cases  to  make  ade- 
quate provision  for  old  age  or  other  contingency.* 

IV.    THE  PECUNIARY  UNIT  AND  ECONOMIC 
ORGANIZATION 

Thus  far  we  have  been  considering  the  pecuniary  unit  in  its 
relation  to  the  making  of  business  and  personal  decisions.  We 
may  now  look  for  some  of  the  broader  economic  and  social 
consequences  of  the  decisions  that  are  made  on  the  basis  of 
pecuniary  computations.  We  have  already  seen  that  without 
an  accurate  means  of  computing  values  extensive  trading 
operations  would  be  impossible.  The  development  of  the 
pecuniary  unit  in  the  various  commercial  nations  has  given 
rise  to  an  international  denominator  of  values,  by  means  of  which 
foreign  transactions  are  greatly  facilitated.  A  merchant  who 
wishes  to  sell  goods  in  a  foreign  country  may  ascertain  the 
profits  from  such  sales  by  simply  translating  dollars  into  pounds 
sterUng,  francs,  or  marks,  as  the  case  may  be.  The  actual 
settlement  of  these  international  financial  obligations,  however, 
has  required  the  development  of  a  rather  complex  financial 
mechanism  known  as  the  foreign  exchanges  (see  chapter  viii). 

It  should  be  noted  here  that  with  narrowly  restricted 
trading  operations  Uttle  division  of  labor  was  possible  and 
small-scale  inefl&cient  production  therefore  necessarily  pre- 
vailed. A  large  volume  of  output  is  absolutely  dependent  upon 
wide  markets — national  and  international;  hence  division  of 
labor  and  large-scale  efl&cient  production  had  to  wait,  among 
other  things,  upon  the  development  of  the  pecuniary  unit  and 
the  extensive  trading  operations  which  it  made  possible. 

Similarly,  territorial  specialization,  whereby  each  portion  of 
the  earth  is  devoted  to  the  production  of  those  commodities 
for  which  it  is  best  adapted,  depends  upon  wide  markets — 

'  See,  however,  the  effect  on  these  calculations  of  unforeseen  changes 
in  the  price  level,  p.  35. 


l4  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

national  and  international.  In  the  absence  of  an  extensive 
commerce  each  region  must  produce  most,  if  not  all,  of  the 
commodities  required  for  its  use. 

Territorial  specialization  is  expedited  by  pecuniary  calculation. 
The  pecuniary  unit  serves  as  a  ready  means  of  indicating  the 
relative  productive  advantages  of  different  regions  and  thus 
directs  and  hastens  the  spread  of  population  to  the  regions  where 
a  given  expenditure  of  effort  will  produce  the  maximum  return. 
There  are,  of  course,  barriers  which  prevent  complete  geo- 
graphical specialization,  such  as  costs  of  transportation  and 
trade  regulations.  Within  a  given  country,  however,  these 
barriers  are  nowadays  usually  neghgible,  and  domestic  terri- 
torial specialization  is  therefore  comparatively  unhampered. 
The  result  is  a  great  augmentation  on  the  volume  of  wealth 
produced. 

Analogous  to  the  spread  of  population  has  been  the  flow 
of  capital  from  the  older  to  the  newer  portions  of  the  world. 
Investors  seek  to  place  their  funds  where  returns  netted  will  be 
highest.  The  pecuniary  unit  makes  possible  a  fairly  accurate 
directing  of  capital  to  the  portions  of  the  world  where  it  will 
be  most  productive.  Sooner  or  later  every  nation  reaches  a 
stage  in  its  industrial  development  when  larger  returns  are  to 
be  obtained  from  investments  abroad  than  from  investments 
at  home.  Without  the  pecuniary  unit  and  the  mechanism  of 
the  securities  markets,'  knowledge  as  to  when  this  stage  has 
been  reached  would  be  uncertain;  hence  the  flow  of  capital  to 
regions  of  greater  productiveness  would  be  more  tardy.  Within 
any  given  country  the  flow  of  capital  from  one  section  to  another 
is  of  course  guided  in  a  similar  manner. 

Pecuniary  accounting  facilitates  the  satisfaction  of  human 
wants.  The  directing  of  labor  and  capital  into  the  various  lines 
of  industry,  guided,  as  we  have  seen,  by  the  pecuniary  unit 
of  calculation,  has  likewise  important  social  results.  The 
reason  why  any  given  line  of  industry  becomes  more  profitable 
than  others  is  that  the  demands  for  the  products  of  such  industry 
are  not  as  adequately  met  by  existing  production  as  is  the  case 

'  See  chap.  xvi.  , 


NATURE  AND  FUNCTIONS  OF  A  PECUNIARY  UNIT   15 

in  other  lines.  The  pecuniary  unit  of  calculation,  which  hastens 
the  diversion  of  labor  and  capital  from  other  lines  into  this  line 
where  the  demand  is  greatest,  thereby  serves  to  satisfy  human 
wants  more  quickly  and  more  adequately  than  would  otherwise 
be  the  case.  This  is  only  another  way  of  saying  that  it  provides 
for  a  larger  satisfaction  of  human  wants  with  the  same  expendi- 
ture of  energy  than  would  otherwise  be  possible. 

Similarly,  if  any  given  line  of  industry  is  waning,  owing  to 
a  decrease  in  the  power  of  its  product  to  satisfy  human  wants, 
the  losses  expressed  in  dollars  and  cents  on  a  balance  sheet 
force  labor  and  capital  out  of  that  line  of  industry  much  more 
quickly  than  would  otherwise  be  the  case.  Hence  misdirected 
labor  and  capital  remain  misdirected  for  a  shorter  time,  with 
the  result  that  the  losses  incident  to  such  misdirection  are 
minimized. 

Again,  in  the  internal  organization  of  any  business,  pecuniary 
calculations  cause  improvements  in  machinery,  labor  organi- 
zation, and  administrative  methods  to  be  made  more  quickly 
than  would  be  the  case  in  the  absence  of  an  accurate  index  of 
profits.  There  is  a  continual  process  of  elimination,  by  means  of 
which  antiquated  industrial  organization  is  rapidly  supplanted, 
the  changes  being  superinduced  by  a  fear  of  pecuniary  loss  on  the 
one  hand,  and  by  the  incentive  to  pecuniary  profit  on  the  other. 
Every  such  improvement  means  an  elimination  of  productive 
waste.  It  means  a  larger  output  with  a  given  expenditure  of 
human  energy;  it  means  that  society  more  easily  wrests  from 
nature  the  means  of  subsistence  and  comfort. 

QUESTIONS  FOR  DISCUSSION 

I.  Note  the  titles  of  the  second,  third,  and  fourth  chapters.  Note 
especially  that  chapter  ii  does  not  relate  to.  the  medium  of 
exchange.    Define  the  term  "pecuniary  unit." 

a.  The  text  indicates  three  stages  in  the  development  of  the  language 
of  business.    What  are  they  ? 

3.  Would  it  be  possible  for  a  business  man  to  keep  accounts  with- 
out a  system  of  notation?  without  a  pecuniary  xmit  of  calcu- 
lation ? 


£6  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

4.  It  has  been  suggested  that  the  standardization  of  grades  of 
commodities  marks  another  stage  in  the  development  of  the 
language  of  business:  it  defines  quaUty  as  well  as  quantity.  Do 
you  agree  ? 

5.  "The  more  highly  developed  our  specialized  exchange  society 
becomes,  the  more  essential  accurate  financial  accounting 
becomes."    Do  you  agree  ? 

6.  "The  larger  the  scale  on  which  business  is  conducted,  the  more 
necessary  is  the  keeping  of  financial  accounts.  The  crossroads 
merchant  has  no  need  of  keeping  accounts."    Do  you  agree  ? 

7.  "Without  accounting  systems  based  on  the  pecuniary  unit  it 
would  have  been  impossible  to  develop  large-scale  industry." 
If  so,  why  ? 

8.  "Modern  business  organization  is  largely  controlled  and  directed 
by  means  of  information  obtained  from  financial  records.  By 
accounts  the  business  manager  ascertains  whether  the  business  as 
a  whole  is  profitable;  whether  each  particular  part  is  profitable; 
and  whether  particular  methods  or  devices  pay.  He  also  formu- 
lates future  business  policy  on  the  basis  of  knowledge  obtained 
from  his  financial  accounts."  Do  all  business  men  do  this  ?  Are 
those  who  do  not  likely  to  survive  in  competition  with  those  who 
do  ?    Will  everyone  who  does  not  do  this  fail  ? 

9.  Do  you  know  of  any  types  of  business  that  are  not  conducted  on 
a  profit-making  basis?  If  so,  are  such  businesses  conducted 
without  reference  to  financial  accounts? 

10.  "The  business  man  endeavors  to  reduce  the  inevitable  risks  of 
industry  as  much  as  possible."  Show  how  financial  accounting 
helps  him  to  do  this. 

11.  What  are  some  of  the  social  consequences  of:  (a)  reduced  risks  in 
business?  (6)  the  accurate  appraisal  of  the  profitableness  of 
the  business  as  a  whole?  (c)  the  accurate  appraisal  of  the 
profitableness  of  particxilar  divisions  of  the  business  ? 

12.  "Not  only  does  the  business  man  control  the  internal  affairs  of 
his  business  by  means  of  financial  accounts;  but  his  external 
relations  with  other  businesses,  with  banks,  and  with  the  govern- 
ment are  also  governed  by  financial  accounts."  *  Do  you  know 

.    of  any  case  where  this  is  not  true  ? 

13.  Indicate  the  service  performed  by  the  pecuniary  unit,  of  calcula- 
tion in  directing  the  flow  of  labor  and  capital  (a)  from  region  to 
region,  (&)  from  industry  to  industry. 


NATURE  AND  FUNCTIONS  OF  A  PECUNIARY  UNIT       17 

[4.  Do  you  or  does  your  family  keep  a  budget?  K  not,  on  what 
basis  is  the  income  apportioned?  Do  you  think  the  largest 
possible  amount  of  satisfaction  is  obtained  from  the  use  of  such 
income  ? 

15.  Is  it  necessary  for  charitable  and  endowed  institutions,  clubs, 
societies,  etc.,  to  make  a  budget?  Is  it  necessary  for  govern- 
ments to  make  budgets? 

16.  The  commissioner  of  internal  revenue  recently  Said  that  2,000 
certified  public  accountants  were  necessary  for  the  successful 
coUection  of  the  federal  taxes  for  191 9.    Why? 

17.  Can  you  think  of  any  form  of  public  control  over  industry  that 
can  be  effectively  administered  without  the  use  of  financial 
accounts  ? 

18.  What  profession  or  occupation  are  you  going  to  follow  as  a  life- 
work  ?  To  what  extent  are  financial  considerations  involved  in 
your  decision  ? 

19.  Do  the  decisions  that  are  rendered  on  the  basis  of  pecuniary 
calculations  always  tend  to  promote  social  welfare  ?    Illustrate. 

20.  The  "profits'  guide"  is  not  a  satisfactory  guide  to  what  is  good 
for  society.  Granting  the  truth  of  this  statement,  what  can 
you  suggest  as  a  better  guide  ? 

21.  Under  a  socialistic  organization  of  society  what  would  be  the 
means  of  arriving  at  business  and  social  decisions  ? 

REFERENCES  FOR  FURTHER  READING 

Holdsworth,  John  Thom:   Money  and  Banking,  pp.  14-16. 
LaughUn,  J.  Laurence:    Principles  of  Money,  chap.  i. 
Moulton,  Harold  G.:    Money  and  Banking,  Part  I,   Selections 
Nos.  26-31,  pp.  31-44. 

Phillips,  Chester  A. :  Readings  in  Money  and  Banking,  chaps,  i,  ii. 
Scott,  WilUam  A.:   Money  and  Banking,  pp.  2-6. 


CHAPTER  ni 

THE  STANDARD   FOR  DEFERRED 
PAYMENTS 

It  was  the  purpose  of  chapter  ii  to  show  the  relation  of  the 
pecuniary  unit  to  financial  accounting,  and  thereby  to  the 
organization  of  both  business  and  household  economics.  It  is 
of  note  that  the  discussion  related  mainly  to  the  rendering  of 
decisions  at  a  given  moment;  it  was  not  concerned  with  trans- 
actions where  the  time  element  was  a  factor.  The  present 
chapter  will  consider  the  function  of  the  pecuniary  unit  in  con- 
nection with  credit  operations  or  deferred  payments. 

Wherever  an  individual  or  corporation  sells  goods  on  time, 
that  is,  on  agreement  that  they  are  to  be  paid  for  at  some  date 
in  the  future,  it  is  highly  important  that  both  buyer  and  seller 
be  protected,  so  far  as  possible,  from  the  risks  that  inhere  in  the 
mere  lapse  of  time.  Because  of  the  interdependency  of  eco- 
nomic institutions  and  their  great  sensitiveness  to  shock, 
economic  changes  of  serious  import  may  occur  during  relatively 
short  periods.  As  one  means  of  minimizing  the  effects  of  such 
changes,  society  has  come  to  use  the  pecuniary  unit,  gold,  as 
the  standard  in  which  deferred  obligations  are  paid. 

The  standard  of  deferred  payments  is  of  importance  not 
merely  in  the  purchase  and  sale  of  actual  commodities.  It  is 
quite  as  important  in  connection  with  the  lending  of  fimds. 
Business  is  largely  conducted  in  the  modern  industrial  world  by 
means  of  borrowed  capital,  represented  by  credit  instruments 
in  the  form  of  stocks,  bonds,  notes,  and  bills  of  exchange.  All 
these  financial  borrowing  operations  involve  risks  of  loss  inci- 
dent to  economic  changes  during  the  life  of  the  loans;  and  it 
is  accordingly  necessary  that  the  standard  for  deferred  pay- 
ments be  a  commodity  which  possesses  a  high  degree  of  value 
stability. 

i8 


STANDARD  FOR  DEFERRED  PAYMENTS  19 

I.    WHY  GOLD  IS  USED  AS  THE  STANDARD 

Aside  from  its  important  qualities  of  durability,  homo- 
geneity, divisibility,  and  cognizibility,  gold  is  especially  superior 
to  other  commodities  as  a  standard  for  deferred  payments  for  the 
reason  that  it  fluctuates  less  widely  than  does  the  value  of 
wheat,  iron,  and  other  commodities  which  might  be  used  for 
the  purpose.^  The  reasons  for  this  relative  stability  of  value 
may  be  readily  indicated. 

Gold,  as  a  commodity,  is  subject  to  the  forces  of  supply  and 
demand  just  as  is  any  other  commodity.  The  supply  of  gold 
is  influenced  directly  by  the  conditions  of  production  at  the 
mines.  The  discovery  of  a  "bonanza"  mine  tends  to  depress 
the  value  of  gold  as  a  standard,  by  greatly  increasing  its  supply; 
and  the  exhaustion  of  a  rich  vein  of  ore  conversely  tends  to 
raise  the  value  of  gold  by  preventing  an  increase  in  supply. 

Changes  in  the  cost  of  producing  gold,  however,  have  not  in 
the  past  had  very  much  effect  upon  the  quantity  produced, 
owing  to  the  speculative  character  of  gold  mining.  It  has  been 
stated  that  the  cost  of  producing  gold  has  probably  on  the 
whole  exceeded  its  value,  that  the  losses  sustained  by  the  many 
who  have  searched  in  vain  have  outweighed  the  gains  made  by 
the  fortunate  few.  But  in  recent  years,  with  the  rapid  dis- 
appearance of  placer  mining  and  the  development  of  machine 
production  of  gold,  the  cost  of  production  has  come  to  be  very 
carefully  considered.  There  are  marginal  mines  where  it  barely 
pays  to  take  out  the  gold,  just  as  there  are  marginal  farms  and 
marginal  factories.  The  increased  cost  of  producing  gold  during 
the  war,  for  instance,  resulted  in  the  closing  of  many  mines 
where  production  had  formerly  been  profitable. 

Gold  differs  from  most  other  commodities  in  that  the  supply 
at  any  given  time  is  not  merely  the  output  of  a  previous  year's 
mining  operations;  it  is  a  stock  that  has  been  accumulated 
through  centuries  of  production.  Gold  is  a  highly  durable 
commodity,  and  as  a  result  the  world's  supply  becomes  larger 

"The  reasons  why  gold  rather  than  silver  came  to  be  used  as  thtt 
standard  are  considered  in  chap,  vi  below. 


20  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

each  year,  even  though  the  annual  production  may  be  rapidly 
decreasing.  The  greater  part  of  all  the  gold  mined  in  modern 
times  is  still  in  existence  and  performing  service  quite  as  though 
it  were  fresh  from  the  mines  of  the  Klondike.  The  result  of 
this  acciunulated  world's  supply  is  to  render  any  yearly  change 
in  output  less  and  less  effective  in  influencing  the  value.  Pour- 
ing a  cup  of  water  into  a  large  tank  has  but  a  slight  effect  upon 
the  level  of  the  water  in  the  tank.  Similarly,  the  discharging 
of  a  $100,000,000  increased  annual  output  of  gold  into  a  total 
world's  supply  of  twelve  or  fourteen  billions  can  have  but  little 
eifect  upon  the  value  of  the  entire  mass.  A  great  increase  in 
gold  production  continued  over  many  years  would,  however, 
obviously  have  a  substantial  effect  upon  the  value  of  the  mass. 

The  demand  for  gold  is  twofold:  (a)  for  use  as  a  commodity 
in  the  manufacturing  and  industrial  arts;  and  (b)  for  employ- 
ment as  a  medium  of  exchange  and  as  the  basis  of  monetary 
systems.  The  demand  for  gold  as  a  commodity  is,  of  course, 
subject  to  the  same  general  conditions  as  the  demand  for  any 
other  commodity.  It  has  utiHty  in  the  satisfaction  of  human 
desires,  and  this  utility  is  affected  by  degree  of  scarcity,  change 
of  custom,  possibility  of  substituting  other  commodities,  etc., 
in  the  same  way  that  the  utihty  of  other  commodities  is  affected. 
For  monetary  uses,  however,  the  demand  for  money,  where  free 
coinage  exists,  is  sometimes  said  to  be  unHmited;  since  all 
the  gold  produced  may  be  taken  to  the  mints  and  converted  into 
dollars  or  sovereigns,  it  would  seem  that  there  is  a  limitless 
demand.  This  view,  however,  overlooks  the  matter  of  intensity 
of  demand.  It  is  true  that  monetary  systems  will  absorb  the 
entire  quantity  of  gold  offered.  But  if  the  supply  of  the  metal 
is  greatly  increased,  the  purchasing  power  of  gold  may  never- 
theless be  lessened.  Nearly  any  quantity  of  wheat  would  be 
demanded,  at  some  price,  but  a  doubling  of  the  total  supply 
would  substantially  lessen  the  exchange  value  of  each  bushel. 
It  is  the  same  with  gold. 

An  increase  in  the  monetary  demand  for  gold  would  be 
caused  by  the  giving  up  of  silver  as  a  standard  metal  in  leading 
countries;  by  an  increased  use  of  gold  as  a  medium  of  exchange; 


STANDARD  FOR  DEFERRED  PAYMENTS  21 

by  an  increase  in  the  quantity  of  gold  required  as  reserve  for 
substitute  forms  of  money;  by  an  expansion  of  commerce  and 
trade;  or  by  a  less  eflFective  use  of  gold  through  poor  organization 
of  credit.  A  decrease  in  the  monetary  demand  for  gold  would 
result  from  opposite  causes. 

In  the  foregoing  discussion  of  the  value  of  gold  we  have  been 
saying,  not  that  gold  is  absolutely  stable  in  value,  but  merely 
that  it  is  more  nearly  stable  than  any  other  commodity  that 
might  be  chosen.  As  a  matter  of  fact,  gold  is  subject  to  wide 
variations  in  value  and  hence  leaves  much  to  be  desired  as 
a  standard  for  deferred  payments.  Great  fluctuations  in  the 
production  of  gold  may  cause  considerable  variations  in  value, 
despite  the  factor  of  durability.  And  the  use  of  credit  instru- 
ments may  serve  greatly  to  reduce  the  demand  for  gold  in  the 
channels  of  circulation.  The  relation  of  credit  instruments  to 
the  value  of  gold  is  one  of  the  most  complex  problems  in  eco- 
nomics. It  cannot  be  taken  up  at  this  place,  for  it  can  be  under- 
stood only  in  the  light  of  a  thorough  analysis  of  banking 
operations. 

n.    RELATION  OF  MONEY  AND  PRICES 

We  have  thus  far  been  speaking  of  the  value  of  gold  and  of 
its  relative  stability  for  the  purposes  of  deferred  payments.  To 
appreciate  fully  the  significance  of  the  standard  of  deferred 
payments,  however,  it  is  necessary  to  understand  the  relation 
of  money  to  prices. 

As  already  stated,  the  quantity  of  money  that  has  been 
chosen  in  the  United  States  as  the  standard,  or  dollar,  is  25  .8 
grains  of  metal,  nine-tenths  gold  and  one-tenth  copper  alloy. 
To  express  the  value  of  another  commodity  in  terms  of  money, 
therefore,  we  always  compare  a  certain  quantity  of  it,  as  a 
pound,  bushel,  or  yard,  with  25.8  grains  of  standard  gold. 
If  a  bushel  exchanges  for  a  dollar,  we  say  the  price  is  one  dollar 
a  bushel,  while  if  it  requires  two  bushels  to  equal  a  dollar  in 
value,  then  we  say  the  price  is  fifty  cents  a  bushel.  The 
value  of  each  particular  commodity  expressed  in  dollars  gives 
US  the  price  of  that  commodity. 


22  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  price  level  is  an  average  of  individual  prices.  It  rises 
or  falls  as  the  value  relation  of  gold  and  commodities  in  general 
changes;  that  is  to  say,  as  the  value  of  gold  falls,  the  level  of 
prices  rises,  and  vice  versa. 

Variations  in  the  price  level  are  shown  by  means  of  an  index 
number.  "An  index  number  of  any  given  article  at  any  given 
date  is  the  percentage  which  the  price  of  that  article  at  that 
date  is  of  the  price  of  the  same  article  at  a  date  or  period  which 
has  been  selected  as  base  or  standard,"  There  are  numerous 
index  numbers  in  use;  and  the  base  or  standard  chosen  varies. 
For  example,  the  index  number  of  the  London  Economist  takes 
as  its  base  the  average  price  of  the  commodities  included  for  the 
years  1845  to  1850.  The  index  number  of  the  Aldrich  (U.S.) 
Senate  Report  takes  average  prices  for  the  year  i860  as  a  base; 
while  the  most  recent  American  index  number,  that  used  to  show 
the  history  of  prices  during  the  Great  War,  is  computed  on  the 
basis  of  average  actual  prices  in  the  twelve  months  preceding 
the  outbreak  of  the  war,  July,  1913,  to  June,  1914,  inclusive. 

The  method  of  computing  index  nvunbers  may  be  illus- 
trated as  follows.  The  average  price  of  each  commodity  for  the 
year  1913  is  considered  as  100.  Then  every  month  the  prices 
of  the  various  commodities  are  turned  into  relatives  on  that 
scale.  Thus  if  wheat  sold  in  1913  at  $1  a  bushel  and  in  May, 
1918,  at  $2 .  26  a  bushel,  the  relative  price  of  wheat  is  then  226. 
If,  on  the  other  hand,  the  price  of  any  commodity  should  drop 
from  50  cents  to  40  cents  the  relative  price  would  be  80.  To 
ascertain  the  change  that  has  occurred  from  month  to  month 
in  the  general  level  of  prices  it  is  only  necessary  to  strike  an 
average  of  these  relative  prices. 

It  is  obvious  that  if  the  index  number  is  to  be  truly  repre- 
sentative of  general  changes  in  prices,  a  large  number  of  com- 
modities must  be  used.  The  index  number  used  in  the  history 
of  prices  during  the  Great  War  is  based  upon  1,371  commodities. 
The  commodities  chosen  are  moreover  weighted  in  accordance 
with  their  relative  importance,  the  reason  assigned  for  this  being 
that  "great  staples  like  bituminous  coal,  yellow  pine  lumber, 
beef,  and  cement  exercise  much  more  influence  upon  the  fiina] 


STANDARD  FOR  DEFERRED  PAYMENTS  23 

results  than  articles  like  horsehair,  hickory,  cinnamon,  and 
bone  buttons. "  In  order  to  make  the  price  level  reflect  the 
greater  importance  of  such  commodities,  they  are  weighted  by 
multiplying  the  monthly  price  of  each  commodity  by  the  quan- 
tity produced  in  and  imported  into  the  United  States  in  191 7. 

The  index  number  of  relative  prices  will  thus  reveal  a 
change  in  the  relative  value  of  the  standard  of  deferred  pay- 
ments and  of  goods  in  general.  It  is  not  to  be  inferred,  however, 
that  a  change  in  the  level  of  prices  is  necessarily  due  to  causes 
directly  touching  the  value  of  the  standard  rather  than  to 
causes  affecting  the  value  of  the  goods  which  are  being  com- 
pared with  the  standard.  The  index  nmnber  merely  reveals 
the  change  in  relationship;  the  cause  of  the  change  is  another 
question. 

It  may  be  said,  however,  that  the  level  of  prices  is  often 
changed  by  forces  operating  directly  upon  the  standard  of  de- 
ferred payments.  This  is  particularly  true  in  cases  where  the 
standard  is  not  a  commodity  which  has  utility  for  other  than 
monetary  purposes.  Some  striking  cases  of  this  are  given  in 
Section  III  below.  This  is  not  the  place,  however,  to  enter 
upon  a  discussion  of  the  complex  causes  of  price  movements. 
The  present  purpose  is  merely  to  reveal  some  of  the  social  and 
economic  results  of  price  fluctuations.  But  it  may  be  stated  in 
passing,  that  the  general  theory  of  the  causes  of  price  fluctu- 
ations is  among  the  most  baflBing  and  complicated  in  the  whole 
realm  of  political  economy. 

m.    ECONOMIC  CONSEQUENCES  OF  PRICE 
CHANGES 

Price  fluctuations,  if  extensive  or  long  continued,  are  always 
disruptive  in  their  effects  upon  the  general  economic  organiza- 
tion. Rapid  price  changes  render  more  difficult  the  pecuniary 
calculations  of  business  men,  thereby  greatly  increasing  the 
risks  of  industry  and  acting  as  a  serious  deterrent  to  business 
enterprise.  The  accumulation  of  capital  is  discouraged,  lend- 
ing or  credit  operations  are  deterred,  speculation  is  induced, 
and  international  financial  relations  are  deranged. 


24  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  recital  of  some  typical  experiences  with  unstable 
monetary  standards  will  best  serve  to  indicate  the  disastrous 
effects  upon  the  economic  system.^  Finlay  tells  us  in  his  History 
of  Greece  that  the  depreciation  in  the  value  of  the  circulating 
medium  during  the  fifty  years  between  the  reign  of  Caracalla 
and  the  death  of  Galienus  annihilated  a  great  part  of  the  trading 
capital  in  the  Roman  Empire,  and  rendered  it  impossible  to 
carry  on  commercial  transactions  not  only  with  foreign  countries 
but  even  with  distant  provinces.  Every  payment  was  liable 
to  be  greatly  diminished  in  real  value,  even  when  it  was  nomi- 
nally the  same.  This  state  of  things  at  last  induced  capitaUsts 
to  hoard  their  coins  of  pure  gold  and  silver  for  better  days; 
and  as  these  better  days  did  not  occur,  all  memory  of  many 
hoards  was  lost,  and  the  buried  treasures,  consisting  of  select 
coins,  have  often  remained  concealed  until  the  present  time. 
Thus  the  frauds  of  the  Roman  emperors  have  filled  the  cabinets 
of  collectors  and  the  national  museums  of  modern  Europe 
with  well-preserved  coins. 

The  laws  which  regulate  the  distribution,  the  accumulation,  and 
the  destruction  of  wealth,  the  demand  for  labor,  and  the  gains  of 
industry  attest  that  the  depreciation  of  ciurrency  was  one  of  the  most 
powerful  causes  of  the  impoverishment  and  depopulation  of  the 
Roman  Empire  in  the  third  century,  and  there  can  be  no  doubt  that 
Greece  suffered  severely  from  its  operation. 

A  second  illustration  may  be  taken  from  the  experience  of 
France  during  the  period  of  the  French  Revolution.  Paper 
currency  had  been  issued  in  great  quantities  in  the  hope  of  pro- 
viding the  liquid  capital  necessary  for  economic  recovery 
from  the  ravages  of  war.  Since  these  paper  "assignats"  were 
legal  tender,  they  became  the  standard  of  deferred  payments. 
Issued  in  vast  quantities  and  irredeemable  in  specie,  they 
fluctuated  widely  in  value  and  eventually  became  utterly 
worthless.  In  a  brillant  monograph'  Andrew  D.  White  portrays 
the  results  in  the  following  language: 

What  the  bigotry  of  Louis  XIV,  and  the  shiftlessness  of  Louis  XV, 
could  not  do  in  nearly  a  century  was  accomplished  by  this  tampering 

'  For  other  illustrations  see  chaps,  vi  and  vi|  bflo^, 
» Paper  Money  Inflation  in  Francf, 


STANDARD  FOR  DEFERRED  PAYMENTS  25 

with  the  currency  in  a  few  months.  Everything  that  tariffs  and 
custom-houses  could  do  was  done.  Still  the  great  manufactories  of 
Normandy  were  closed;  those  of  the  rest  of  the  kingdom  speedily 
followed,  and  vast  numbers  of  workmen  in  all  parts  of  the  country 

were  thrown  out  of  employment In  the  spring  of  1791  no 

one  knew  whether  a  piece  of  paper  money,  representing  100  francs, 
would,  a  month  later,  have  a  purchasing  power  of  100  francs  or  90 
francs,  or  80  or  60.  The  result  was  that  capitalists  declined  to 
embark  their  means  in  business.  Enterprise  recei^-ed  a  mortal  blow. 
Demand  for  labor  was  still  further  diminished.  The  business  of 
France  dwindled  into  a  mere  living  from  hand  to  mouth.  This 
state  of  things,  too,  while  it  bore  heavily  against  the  interests  of  the 
moneyed  classes,  was  still  more  ruinous  to  those  in  more  moderate, 
and  most  of  all  to  those  in  straitened,  circumstances.  With  the 
masses  of  the  people  the  purchase  of  every  article  of  supply  became 
a  speculation — a  speculation  in  which  the  professional  speculator 
had  an  immense  advantage  over  the  buyer.  Says  the  most  brilliant 
apologist  for  French  Revolutionary  statesmanship,  "  Commerce  was 
dead;  betting  took  its  place." 

The  use  of  inconvertible  greenback  currency  disorganized  trad- 
ing methods.  A  more  recent  experience  with  a  rapidly  fluctuat- 
ing standard  of  deferred  payments  is  that  of  our  own  Civil  War. 
As  a  means  of  financing  the  war,  the  government  issued  $400,- 
000,000  of  United  States  notes,  popularly  known  as  greenbacks. 
These  notes  were  not  redeemable  in  specie  upon  demand;  they 
were  merely  promises  of  the  government  to  pay  at  some  future 
time,  date  uncertain.  Indeed,  their  ultimate  redemption  in 
specie  was  dependent  upon  the  outcome  of  the  war  and  upon 
future  pohtical  and  economic  considerations.  In  any  event,  it 
was  certain  that  not  until  the  war  should  be  over  would  it  be 
possible  for  the  government  to  accumulate  the  necessary  specie 
reserve  with  which  to  redeem  and  retire  them. 

Since  the  value  of  these  greenbacks  depended  upon  the 
intention  and  the  ability  of  the  government  ultimately  to  redeem 
them  in  specie,  their  value  fluctuated  with  the  probabilities  of  an 
early  or  remote  successful  ending  of  the  war.  At  one  time  the 
value  of  a  dollar  greenback  was  less  than  forty  cents  in  gold; 
and  throughout  the  war,  as  well  as  for  fourteen  years  thereafter 


26  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

(they  were  not  convertible  into  gold  until  January  i,  1879),  they 
were  at  a  substantial  discount.  The  chart  on  page  31  indicates 
the  fluctuations  that  occurred. 

Since  the  greenbacks  were  legal  tender  in  the  settlement  of 
obUgations,  everybody  preferred  to  use  them  in  making  pay- 
ments instead  of  the  more  expensive  money,  gold  and  silver. 
Their  rapid  fluctuation  in  value,  however,  made  them  a  very 
unsatisfactory  standard,  one  result  of  which  was  to  cause  wide- 
spread disorganization  in  mercantile  trade  and  ultimately  to 
modify  profoundly  the  method  of  conducting  mercantile  busi- 
ness in  this  country. 

Before  the  Civil  War  it  was  customary  for  the  jobbing  and 
wholesale  establishments  of  eastern  cities  to  sell  goods  to 
retailers  in  the  West  on  long-term  credits,  usually  a  year's  time. 
The  country  merchant  came  to  New  York  once  a  year  and  laid 
in  supplies  suificient  for  a  twelve  months'  business,  to  be  paid 
for  at  the  end  of  the  year.  But  when  payments  began  to  be 
made  in  greenbacks,  the  fluctuations  in  value  from  January  to 
December  proved  so  great  that  business  men  were  deterred 
from  extending  credit  for  so  long  a  period.  "The  internal 
credit  system  of  the  country  broke  down,"  says  Horace  Greeley, 
"and  rural  traders,  no  longer  able  to  replenish  their  stocks  on 
credit,  bought  little  or  nothing."  On  September  9,  1865,  the 
Commercial  and  Financial  Chronicle  stated  that  most  jobbing 
sales  were  on  short  time,  from  sixty  days  to  four  months;  but 
if  settled  within  thirty  days  from  date  a  discount  of  i  per 
cent  a  month  was  allowed,  including  interest  for  the  first  thirty 
days.  Most  buyers  took  advantage  of  these  terms.  It  will 
be  noted  that  the  sellers  of  the  goods  were  thus  willing  to  knock 
off  12  per  ceijt  a  year  in  order  to  be  relieved  of  the  risks  caused 
by  a  fluctuating  standard.  It  is  of  interest  that  the  practice  thus 
begun  continued  even  after  greenbacks  had  come  to  a  parity  with 
gold  in  1879.  In  fact,  it  has  persisted  down  to  the  present  time, 
with  the  result  that  we  now  have  in  some  respects  a  very 
different  type  of  commercial  organization  than  exists  else- 
where.* 

'  See  p.  169. 


STANDARD  FOR  DEFERRED  PAYMENTS  27 

The  depreciation  of  the  greenbacks  also  greatly  increased 
the  hazards  of  foreign  trade.  A  very  interesting  practice  of 
protecting  one's  self  against  variations  in  prices,  while  waiting 
for  payments,  developed — that  of  selling  gold  short  on  the  gold 
exchange,  an  institution  which  was  organized  as  soon  as  the 
greenbacks  became  the  pecuniary  standard  and  gold  a  com- 
modity quoted  in  terms  of  greenbacks. 

The  free  silver  agitation  deranged  international  finance.  The 
results  of  an  unsettled  or  unstable  standard  of  deferred  pay- 
ments upon  business  organization  find  no  better  illustration 
than  in  an  American  experience  of  the  early  nineties.  The 
single  gold  standard  had  been  decreed  by  the  Act  of  1873, 
afterward  known  as  the  "crime  of  '73,"  which  omitted  the  silver 
dollar  from  the  list  of  coins  that  could  be  struck  at  the  mint. 
Powerful  interests,  however,  supported  the  restoration  of  the 
bimetaUic  standard;  with  the  result  that  the  Bland- Allison 
Act  of  1878  partially  restored  the  coinage  of  silver,  while  the 
Sherman  Act  of  1890  still  further  increased  the  amount  of 
silver  that  must  annually  be  converted  into  currency. 

This  latter  act  provided  that  silver,  purchased  by  the  govern- 
ment, could  be  paid  for  by  means  of  an  issue  of  legal  tender 
Treasury  notes,  redeemable  in  either  gold  or  silver  at  the  dis- 
'cretion  of  the  Secretary  of  the  Treasury.  At  the  time,  the 
bullion  in  a  silver  dollar  was  worth  only  a  little  over  fifty  cents, 
and  silver  coins  were  kept  at  a  parity  with  gold  by  virtue  of  the 
government's  willingness  to  accept  silver  as  the  equivalent  of 
gold  in  the  payment  of  taxes,  etc.  Under  these  circumstances,  if 
the  Treasurer  had  refused  to  redeem  these  Treasury  notes  in 
gold  the  result  would  have  been  to  destroy  the  parity  value  of 
silver  and  gold;  since  the  Treasury  notes  would  have  been 
redeemable  only  in  silver,  the  country  would  in  effect  have  been 
thrown  upon  a  depreciated  silver  basis.  Deferred  obligations 
would  then  have  been  payable  in  dollars  that  were  worth  only 
about  half  as  much  as  the  dollars  in  which  they  had  been  con- 
tracted. The  Secretary  of  the  Treasury  wisely  took  the  stand 
that  he  would  never  refuse  to  redeem  them  in  gold,  so  long  as 


28  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

there  were  available  funds  in  the  Treasury.  In  order  to  main- 
tain gold  payments,  however,  it  proved  necessary  for  the 
government  to  replenish  the  Treasury  in  1894  and  1895  by  a 
series  of  bond  issues. 

While  suspension  of  gold  redemption  was  thus  avoided,  the 
imminent  possibility  for  several  years  of  precipitating  the 
country  upon  a  depreciated  silver  basis,  together  with  a  power- 
ful agitation  for  a  complete  restoration  of  the  bimetallic  standard 
of  fold  and  silver — which  would  have  meant  a  cheaper  stan- 
dard— nevertheless  worked  havoc  with  American  finance  and 
industry.  In  the  first  place,  it  destroyed  the  confidence  of 
foreign  investors  in  American  securities.  If  the  interest  on  the 
principal  of  these  investments  were  to  be  paid  in  silver,  the 
purchasing  power  of  which  was  only  about  half  that  of  gold, 
the  value  of  European  investments  would  thus  be  cut  in  two. 
During  the  latter  part  of  1892,  the  year  1893,  and  the  early  part 
■of  1894,  it  is  estimated  that  about  $300,000,000  of  European 
securities  were  returned  to  the  United  States  by  their  foreign 
owners  because  of  the  uncertainty  of  the  standard  in  this 
country;  and  at  the  same  time  the  annual  increase  of  new  Euro- 
pean investments  was  largely  curtailed.  This  necessitated 
large  exports  of  gold;  and  this  in  turn  greatly  embarrassed  the 
Treasury  in  its  efforts  to  maintain  the  convertibility  of  all  forms 
of  currency  into  gold,  because  the  banks  could  obtain  the  gold 
required  for  export  only  by  presenting  Treasury  notes  (and 
greenbacks)  to  the  Treasury  for  redemption.  While  there  were 
at  work  during  this  period  other  factors  which  had  an  important 
bearing  on  the  general  financial  situation,  the  uncertainty  of  the 
standard  of  deferred  payments,  on  the  basis  of  which  all  time 
obligations  are  undertaken,  was  a  primary  source  of  difficulty. 

Domestic  finance  was  also  disorganized.  Moreover,  it  was 
not  alone  foreign  investments  that  were  thrown  out  of  adjust- 
ment. Domestic  financiers  who  had  debts  which  called  for 
payment  in  gold  at  maturity  found  themselves  in  a  quandary. 
If  they  accepted  the  Treasury  notes  (and  this  they  must  do 
because  they  were  legal  tender)  in  ordinary  business  operations, 
CQuJcJ  they  safely  hold  and  use  these  notes  until  debts  matured 


STANDARD  FOR  DEFERRED  PAYMENTS  29 

and  then  exchange  them  at  the  Treasury  for  the  gold  required  to 
fulfil  their  gold  obligations  ?  The  answer  depended  on  whether 
the  Treasurer  should  continue  to  redeem  the  notes  in  gold  as 
well  as  in  silver  coins.  The  uncertainty  of  the  situation  caused 
many  business  men  to  present  notes  for  redemption  as  fast  as 
they  were  received,  instead  of  waiting  until  the  gold  was  actually 
needed.  For  so  long  as  the  Treasury  continued  to  pay  in  gold, 
the  gold  withdrawn  could  be  hoarded,  thereby  making  certain 
the  meeting  of  gold  obligations  when  they  should  mature.  But 
this  constant  draining  of  the  Treasury  of  its  gold  supply  only 
served  to  render  more  precarious  the  ability  of  the  Treasury  to 
maintain  the  gold  standard;  and  this  in  turn  served  to  intensify 
the  general  uncertainty. 

If  existing  contracts  were  rendered  unsatisfactory  and 
precarious  by  virtue  of  this  uncertainty  over  the  future  of  the 
standard,  it  is  easy  to  see  that  individuals  would  hesitate  to 
incur  additional  long-time  obligations.  The  investment  and 
loan  market  was,  in  fact,  demoralized. 

Rising  prices  now  handicap  Germany's  export  trade:^ 

The  tremendous  revolution  of  prices  which  has  shocked  oxur 
economic  body  during  recent  months  has  rendered  it  nearly  impos- 
sible for  industry  to  make  exact  calculations  and  to  stick  to  them 
for  a  definite  period.  Efforts  are  made  to  set  up  fixed  price  lists; 
but  this  is  done  in  vain  so  long  as  wUd  fluctuations  take  place  in 
the  raw  material  markets  and  so  long  as  new  wage  demands  are 
advanced  by  labor  almost  daily,  demands  which  appear  to  be  justified 
because  of  the  rapidly  rising  cost  of  living. 

In  order  to  rely  somewhat  on  fundamental  prices  the  majority 
of  industrial  concerns  have  adopted  the  system  of  an  additional 
price  imposed  upon  a  standard  basis.  But  this  system  is  practically 
useless  today,  as  these  additional  prices  are  higher  than  the  funda- 
mental prices.  The  additional  charges  must  be  increased  constantly, 
and  these  price  changes  are  fraught  with  serious  consequences, 
especially  if  the  time  of  delivery  must  be  postponed  on  account  of 
deficiency  of  coal,  raw  materials,  or  strikes.  In  accepting  orders 
these  circumstances  act  in  a  most  disagreeable  way,  as  the  settlement 

'  From  foreign  correspondence  of  the  New  York  Evening  Post,  March  20, 
T020. 


30  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

of  prices  must  be  made  under  such  restrictions  as  to  give  them  the 
character  of  orders  in  blank.  This  is  a  particular  drawback  for 
exf>orters  who,  in  competition  with  foreign  competitors,  must  appear 
on  the  market  with  fixed  prices. 

The  exporter  who  does  not  want  to  suffer  losses  is  therefore 
forced  to  alter  his  prices  in  the  end,  and  the  foreign  customer  who 
is  not  entirely  informed  about  the  prevailing  drciunstances  shows  no 
appreciation  of  the  reasons  for  these  fluctuations  and  is  only  too 
wilUng  to  attribute  them  to  ill-will  or  deliberate  deceiving.  The 
consequences  are  an  accumulation  of  complaints  about  unreliable 
management  of  German  business  and  a  gradually  growing  distrust, 
even  of  old  firms  of  formerly  worldwide  reputation. 

The  price  level  changes  more  or  less  continuously.  The  fore- 
going are  rather  extreme  cases  of  price  fluctuations  and  their 
effects  upon  industry.  The  general  level  of  prices,  however,  is 
always  changing  more  or  less,  owing  to  causes  which  need  not  be 
considered  here.  From  1850  to  1865,  for  example,  there  was  a 
substantial  increase  in  the  level  of  prices;  from  1865  to  1896 
there  was  a  great  decrease  in  the  price  level;  from  1896  to  1914 
there  was  a  marked  rise;  while  from  i9i4toi9i8  the  price  level 
advanced  by  practically  100  per  cent.  The  Great  War  may  or 
may  not  be  followed  by  a  substantial  recession  in  prices,  as  was 
the  case  after  the  Civil  War.  The  chart  on  the  opposite  page 
shows  the  variations  that  have  taken  place  in  the  price  level 
in  the  United  States  from  1840  to  the  present  time. 

IV.    PRICE  CHANGES  AND  SOCIAL 
MAL-ADJUSTMENTS 

In  the  foregoing  illustrations  we  have  considered  the  effects 
of  changes  in  the  level  of  prices  upon  the  risks  of  industry  and 
hence  upon  the  stability  of  business  enterprise.  We  shall  now 
see  that  price  changes  produce  other  maladjustments,  which 
are  of  almost  as  great  importance.  Social  maladjustments 
are  caused:  (i)  between  borrowers  and  lenders,  or  debtor  and 
creditor  classes;  and  (2)  in  the  real  income  of  the  salaried  and 
wage-earning  classes. 

Price  changes  disrupt  the  equities  between  debtors  and  creditors. 
The  effects  of  the  depreciated   paper  of   the   Revolutionary 


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52  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

War  period  upon  the  debtor  and  creditor  classes  have  been 
vividly  described  by  a  writer  of  the  time,  as  follows:* 

The  aged  who  had  retired  from  the  scenes  of  active  business  to 
enjoy  the  fruits  of  their  industry  found  their  substance  melting  away 
to  a  mere  pittance,  insufficient  for  their  support.  The  widow  who 
lived  comfortably  on  the  bequests  of  a  deceased  husband  experienced 
a  frustration  of  all  his  weU-meant  tenderness.  The  laws  of  the 
country  interposed,  and  compelled  her  to  receive  a  shilling  where  a 
pound  was  her  due.  The  blooming  virgin  who  had  grown  up  with 
an  unquestionable  title  to  a  liberal  patrimony  was  legally  stripped  of 
everything  but  her  personal  charms  and  virtues.  The  hapless  orphan, 
instead  of  receiving  from  the  hands  of  an  executor  a  competency  to 
set  out  in  business,  was  obliged  to  give  a  final  discharge  on  the  pay- 
ment of  6d.  in  the  pound.  In  many  instances,  the  earnings  of  a  long 
hfe  of  care  and  diligence  were,  in  the  space  of  a  few  years,  reduced  to  a 
trifling  sum.  A  few  persons  escaped  these  affecting  calamities  by 
secretly  transferring  their  bonds,  or  by  flying  from  the  presence  or 
neighborhood  of  their  debtors.  A  hog  or  two  would  pay  for  a  slave; 
a  few  cattle  for  a  comfortable  house ;  and  a  good  horse  for  an  improved 
plantation.  A  small  part  of  the  production  of  a  farm  would  dis- 
charge the  long-outstanding  accounts,  due  from  its  owner.  The 
dreams  of  the  golden  age  were  realized  to  the  poor  man  and  the 
debtor,  but  unfortunately  what  these  gained  was  just  so  much  taken 
from  others. 

Another  illustration — less  extreme — is  found  in  the  green- 
back currency  of  our  Civil  War  era.  The  general  fall  in  prices 
after  the  war,  incident  to  the  appreciation  of  greenbacks  as 
compared  with  gold,  was  bitterly  opposed  by  the  debtor  classes; 
but  it  was  looked  upon  with  composure,  and  even  championed, 
by  the  creditor  classes.  The  reason  for  this  was  that  a  fall  in 
prices  impaired  the  economic  position  of  debtors  and  improved 
the  economic  position  of  creditors.  It  should  be  understood 
here  that  by  debtors  is  meant  not  merely  the  ne'er-do-wells, 
people  who  are  poverty  stricken,  shiftless,  and  hopelessly  in 
arrears.  The  debtor  class  is  composed  most  largely  of  indi- 
viduals and  corporations  who  have  borrowed  capital  for  use  in 
business  enterprises  of  various  sorts.     For  instance,  the  farms  of 

*  David  Ramsay,  History  of  American  Revolution  (1789).  PP-  I34-.3S- 


STANDARD  FOR  DEFERRED  PAYMENTS  33 

the  Middle  West  were  largely  purchased  on  borrowed  funds.  A 
small  accumulation  was  sufficient  to  make  an  initial  payment, 
and  a  mortgage  was  given  for  the  balance.  Out  of  the  income 
from  the  farm,  the  owner  paid  interest  on  his  mortgage  and 
gradually  reduced  the  principal,  thus  eventually  acquiring 
complete  ownership,   \ 

The  fall  in  the  prices  of  farm  products  after  the  Civil  War 
made  it  very  difficult  to  pay  mortgages  as  they  fell  due,  with 
the  result  that  a  large  percentage  of  them  were  extended  again 
and  again.  Since  a  falling  price  did  not  increase  the  number  of 
bushels  grown  per  acre,  the  farmer  found  his  actual  income 
reduced.  FaUing  prices  thus  meant  hard  times,  inability  to 
get  ahead  in  the  world.  The  result  was  a  great  popular  resent- 
ment against  a  contraction  of  the  volume  of  currency,  which 
was  deemed  responsible  for  the  fall  in  prices;^  and  for  more  than 
a  generation  the  money  question  overshadowed  all  other  issues  in 
American  politics.' 

The  view  of  the  debtors  was  well  expressed  in  the  following 
statement  made  by  Congressman  Voorhees  in  189 1:^ 

It  may  be  stated  without  the  slightest  fear  of  contradiction  that 
the  attack  upon  silver  money  in  this  and  other  countries  is  based 
upon  no  demerit  or  unsoundness  on  its  part,  but  is  simply  a  movement 
for  the  contraction  of  the  currency.  This  movement  is  made  by 
the  moneyed  classes  who  wish  to  increase  the  purchasing  and  interest- 
gathering  power  of  money  in  their  own  hands  by  making  it  scarce  in 
the  hands  of  others;  by  people  with  large  incomes  growing  out  of 
monopolies  protected  by  unjust  legislation;  by  those  who  enjoy 
annuities,  interest  in  public  securities,  fixed  salaries  under  great  cor- 
porations and  by  the  creditor  classes  in  general,  including  all  the 

'  A  similar  opposition  to  a  fall  in  prices  after  the  Great  War  is  mani- 
fested by  the  agricultural  interests. 

*  It  is  not  to  be  understood  from  this  statement  that  the  attitude  of  the 
debtor  class  was  alone  responsible  for  the  agitation  for  greenback  currency 
and  a  restoration  of  bimetallism  during  the  period  in  question;  for  nimaerous 
other  interests  were  involved.  For  a  good  discussion  of  the  entire  problem 
see  R.  F.  Hoxie,  "The  Silver  Debate  of  1890,"  Journal  of  Political  Economy, 
I  (1892-93),  545-73. 

»  From  "A  Plea  for  Free  Silver,"  North  American  Review,  CLIII  (1891), 
S29riO. 


34  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

enormous  loan  associations,  who  join  in  the  movement  of  silver 
destruction  and  financial  contraction  in  order  to  enhance  twofold 
and  more  the  value  and  power  of  the  money  they  wring  from  the 
hands  of  the  laboring  people.  This  will  result  in  the  practical 
enslavement  of  those  who  are  in  debt  and  who  toil  for  a  living. 
The  policy  of  contraction  is  the  policy  of  organized,  imsparing, 
pitiless  avarice. 

The  viewpoint  of  the  creditor  class  is  found  in  the  following 
statement  by  Francis  A.  Walker,  one  of  the  most  eminent 
economists  of  his  day,  at  the  time  president  of  the  Massachusetts 
Institute  of  Technology:^ 

The  inflationists,  like  the  poor,  we  have  always  with  us.  Political 
education,  the  growth  of  sound  economic  ideas,  the  establishment  of 
manufactures,  trade,  and  banking  will  do  much  to  diminish  the 
nimiber  of  the  members  of  this  class;  but  humanity  will  have  to  pass 
through  many  more  stages  of  refinement  and  education  before  that 
element  will  be  entirely  eliminated.  The  instinct  of  spoliation  and 
confiscation,  the  passion  for  making  something  out  of  nothing  and 
much  out  of  little,  the  desire  to  pay  debts  in  depreciated  currency, 
are  too  deeply  implanted  in  poor,  fallen  human  nature,  to  give  way 
altogether  either  to  ethical  instruction  or  to  demonstrating  that  in  the 
long  run  honesty  is  the  best  policy.  Thdre  are  tens  of  thousands  of 
people  in  Massachusetts  today  who,  if  removed  west  of  the  Missis- 
sippi, or  only  even  beyond  the  Alleghenies,  would  be  rampant  infla- 
tionists, but  are  here  overawed  by  the  dominant  sentiment  of  the 
commimity,  or  are  silent  because  they  see  no  chance  to  act  with 
effect  in  such  a  hopeless  minority. 

With  the  reverse  movement  of  prices  that  began  in  1896, 
it  soon  became  a  horse  of  another  color.  The  rise  in  the  general 
level  of  prices  meant  that  it  became  increasingly  easy  for  those 
who  had  borrowed  funds  to  meet  interest  payments  and  to 
reduce  the  principal  when  the  obligations  matured.  Farmers, 
for  instance,  did  not  need  to  raise  a  larger  number  of  bushels  of 
wheat  in  order  to  secure  larger  incomes  when  the  price  of  wheat 
was  advancing.  On  the  other  hand,  lenders  who  received  this 
interest  and  principal  found  that  the  dollars  received  in  pay- 
ment would  not  go  so  far  as  formerly  in  purchasing  commodities. 

*  FVom  Journal  of  Political  Economy,  I  (i89a-03),  166. 


STANDARD  FOR  DEFERRED  PAYMENTS  35 

The  real  return  on  the  money  mvested  was  thus  diminished; 
while  the  shrinkage  in  value  of  the  investment  itself  often 
produced  serious  consequences. 

When  we  speak  of  creditors  in  this  connection,  we  have  in 
mind  not  merely  large  capitalists  who  have  money  invested. 
The  term  includes  all  people  who  put  money  in  savings  banks, 
take  out  insurance,  and  invest  in  bonds.  Widows  and  orphans 
on  fixed  incomes  from  investments  find  their  annual  purchasing 
power  steadily  reduced.  A  larger  amount  of  insurance  is 
required  to  afford  the  necessary  protection  to  one's  dependents, 
and  the  volume  of  savings  that  must  be  set  aside  for  old  age 
must  be  increased. 

A  rise  in  the  general  level  oj  prices  causes  serious  variations  in 
real  salaries  and  wages.  Only  in  case  salaries  were  increased 
proportionally  to  the  increase  in  the  prices  of  those  commodities 
which  enter  into  the  consumption  of  the  salaried  man  could  a 
fall  in  his  real  income  be  avoided.  But  the  truth  is  that  salaries 
almost  never  advance  in  step  with  an  increase  of  prices.  There 
are  numerous  reasons  for  this. 

First,  there  is  a  great  deal  of  inertia  to  be  overcome.  Second, 
salaried  men  are  seldom  organized  and  they  can  therefore  bring 
no  concerted  pressure  to  bear.  Third,  there  are  many  cases 
where  the  employer  cannot  raise  salaries  without  serious  financial 
consequences.  This  is  particularly  true  in  the  case  of  insti- 
tutions whose  income  is  largely  derived  from  fixed  investments, 
themselves  subject  to  adverse  effects  of  rising  prices.  Fourth, 
there  is  usually  the  hope,  if  not  the  expectation,  that  prices  will 
shortly  recede  again;  and  since  salaries  once  raised  are  diflScult 
to  lower,  it  is  regarded  as  the  part  of  wisdom  to  make  no  pre- 
mature salary  advances. 

Wages  show  more  of  a  tendency  to  rise  with  prices  than  do 
salaries,  although  there  has  usually  been  a  considerable  lag  in 
wages,  due  in  general  to  the  same  forces  that  operate  to  prevent 
an  increase  in  salaries.  But  where  laborers  are  strongly 
organized,  an  early  increase  of  wages  is  usually  secured.  And 
since  it  is  usually  industrial  concerns,  which  are  making  good 
profits  in  a  period  of  rising  prices,  that  employ  wage-earners, 


36  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

it  is  often  easier  to  make  the  adjustments  than  is  the  case  with 
the  salaried  class,  so  many  of  whom  are  in  the  employ  of  insti- 
tutions which  are  dependent  upon  fixed  investments  or  upon 
an  increase  in  public  taxes. 

A  factor  of  great  importance  in  connection  with  the  wage 
situation  in  a  period  of  advancing  prices  is  that  in  tKe  early 
stages  of  the  price  increase  there  is  usually  very  active  business, 
and  hence  steady,  as  opposed  to  intermittent,  employment. 
Even  though  wage  rates  do  not  advance  as  rapidly  as  prices,  the 
aggregate  annual  wage  may  nevertheless  for  a  time  keep  pace 
with  the  cost  of  living.  There  is  always  an  end  to  this  com- 
pensating advantage,  however,  for  there  is  a  limit  to  the  number 
of  hours  per  day  and  the  number  of  days  per  year  that  a  laborer 
can  work.  Eventually,  the  laborer  always  feels  keenly  the 
effects  of  a  general  advance  in  prices. 

Because  of  the  difficulty  in  lowering  wages  and  salaries  that 
have  once  been  raised,  employers  prefer  to  give  bonuses  during 
periods  of  rising  prices,  as  a  means  of  adjusting  incomes.  A 
bonus  does  not  become  a  permanent  part  of  an  employee's 
income;  it  is  in  its  very  nature  a  temporary  adjustment.  Hence 
if  prices  later  recede,  the  bonus  may  be  omitted  without  vigorous 
opposition  on  the  part  of  employees.  Bonuses  take  many  forms 
and  there  is  no  general  agreement  as  to  the  most  satisfactory 
type.  One  feature  appears  to  be  common,  however,  that  of 
giving  a  larger  bonus  to  those  in  the  lower  ranges  of  salaries 
and  wages,  on  the  principle  that  these  classes  are  nearest  the 
minimum  of  subsistence  and  therefore  stand  in  greatest  need  of 
reUef. 

One  of  the  most  distressing  results  of  rising  prices  is  that  it 
becomes  increasingly  difficult  for  those  who  most  need  to  make 
adequate  provision  for  the  future  to  make  such  provision.  Since 
the  annual  purchasing  power  of  one's  income  is  decreased, 
customary  savings,  to  say  nothing  of  compensatory  savings  with 
which  to  offset  the  rise  of  prices,  can  be  secured  only  by  a  reduc- 
tion in  the  standard  of  living,  something  extremely  difficult  to 
countenance.  The  general  problem  is  complicated  by  the  fact 
that  few  people  have  any  means  of  knowing  in  advance  what  the 


STANDARD  FOR  DEFERRED  PAYMENTS  37 

trend  of  prices  is  likely  to  be.  Hence  it  is  virtually  impossible  to 
adjust  one's  savings  to  the  changing  needs  of  the  situation. 
Security  against  the  vicissitudes  of  existence  thus  becomes  more 
uncertain;  and  the  risks  of  life  are  substantially  increased. 

Since  the  real  return  from  fixed  investments  is  a  diminish- 
ing one  during  periods  of  rising  prices,  it  is  preferable  at  such 
a  time  to  invest  in  stocks  rather  than  bonds.  The  reason  for 
this  is  that  the  income  from  stocks  is  not  fixed  and  is  likely  to 
increase  as  prices  rise.  Since  the  monetary  value  of  the  invest- 
ment rises  with  the  price  level,  the  original  investment  does 
not  shrink  as  it  does  in  the  case  of  bonds.  While  men  of  affairs 
may  well  take  advantage  of  this  factor,  knowledge  of  it  affords 
small  comfort  to  those  who  are  most  adversely  affected  by  a 
changing  price  level,  namely,  dependents  with  small  knowledge 
of  business  and  of  the  character  of  specific  shares  of  stock.  The 
risks  involved  in  purchasing  stocks,  together  with  the  inability, 
in  most  cases,  to  distribute  the  risks  adequately  by  a  variety  of 
investments,  generally  necessitates  those  dependent  upon  an 
income  from  investments  to  purchase  bonds  rather  than  stocks. 

During  a  period  of  falling  prices  results  opposite  to  those 
portrayed  above  tend  to  work  out.  Salaries  are  usually  not 
reduced  as  prices  fall,  and  the  real  income  of  the  salaried  man 
therefore  increases.  While  wages  fall,  they  do  not  as  a  rule 
decline  as  rapidly  as  prices;  and  the  laboring  class  would 
accordingly  also  find  its  standard  of  living  improved  were  it  not 
for  the  fact  that  a  period  of  falling  prices  is  usually  a  period  of 
dull  times,  during  which  the  employer  endeavors  to  minimize  his 
losses  by  reducing  the  number  of  men  on  the  pay-roll.  It 
is  therefore  commonly  urged  that  labor  always  gets  the  short 
end  of  things. 

QUESTIONS  FOR  DISCUSSION 

1.  Why  was  the  function  of  money  as  a  standard  of  deferred  pay- 
ments of  comparatively  late  development  ?  Is  it  a  result  or 
a  cause  of  industrial  progress  ? 

2.  Does  the  same  commodity  usually  serve  both  as  a  pecuniary  unit 
or  common  denominator  of  values,  and  as  a  standard  of  deferred 
payments  ?    Is  this  necessarily  the  case  ? 


38  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

3.  What  is  the  difference  between  value  and  price? 

4.  What  is  the  value  of  the  dollar  unit  ? 

5.  What  is  meant  by  the  mint  price  of  gold?    What  is  the  mint 
price  of  standard  gold  ? 

6.  What  is  meant  by  the  level  of  prices  ?    How  is  it  determined  ? 

7.  To  what  various  uses  may  an  index  number  of  relative  prices  be 
put? 

8.  What  factors  govern  the  value  of  gold  as  a  commodity  ? 

9.  Have  we  ever  reached  the  ideal  in  the  matter  of  a  standard  for 
deferred  payments  ?  of  a  pecuniary  unit  ? 

10.  Why  should  a  fluctuating  standard  of  deferred  payments  have 
deterred  "saving"  in  Rome?  Why  should  it  have  deterred 
capitalistic  enterprise  in  general? 

11.  Why  did  the  fluctuating  standard  of  paper  currency  at  the  time 
of  the  French  Revolution  result  in  wild  speculation  ? 

12.  During  the  period  of  depreciated  greenback  currency  in  the 
United  States,  do  you  think  the  wholesale  merchant  was  justified 
in  requiring  cash  payments  or  very  short-time  credit  terms  ? 

13.  Was  the  system  of  cash  discounts  that  was  developed  fair  to  the 
buyer?   to  the  seller? 

14.  Does  a  fluctuating  standard  interfere  more  with  short-  or  with 
long-term  credit  operations  ?    Why  ? 

15.  Why  should  European  investors  have  sold  American  securities 
in  the  early  nineties,  when  it  was  thought  the  United  States 
might  resort  to  a  sUver  standard  ? 

16.  Would  the  conditions  that  existed  in  the  early  nineties  have 
deterred  you  from  making  long-time  loans  ? 

17.  "A  debt  for  $1,000  that  1,000  bushels  would  have  paid  ten  years 
ago  now  requires  the  farmer  to  give  up  2,000  bushels  of  wheat,  in 
exchange  for  these  dollars,  with  which  to  pay  the  same  debt. 
The  debts  now  in  existence  are  principally  old  debts  or  renewed 
or  funded  debts,  or  new  debts  contracted  to  pay  old  debts,  or 
debts  which  the  people  have  been  forced  to  contract  by  reason 
of  the  continued  decline  of  prices.  The  owners  of  products  must 
now  give  up  twice  as  much  property  to  pay  the  taxes  as  in  1873  " 
(open  letter  to  President  Cleveland,  April,  1894J  distributed 
among  farmers  in  a  pamphlet).     Dbcuss. 

18.  To  your  way  of  thinking,  was  it  the  moral  duty  of  the  debtors  to 
stand  by  their  contracts  ?  Suppose  prices  had  risen,  would  the 
debtors  have  advocated  a  contraction  of  the  currency  ? 


STANDARD  FOR  DEFERRED  PAYMENTS  39 

19.  "I  object  to  the  silver  standard  being  adopted  in  lieu  of  the 

existing  standard,  because  it  will  defraud  all  creditors  out  of 
one-half  of  the  value  of  their  debts.  Every  debt  contracted  since 
January  i,  1879,  was  contracted  on  the  gold  standard.  The 
debtor  honestly  owes  the  value  of  23. 22  grains  of  gold  for  every 
dollar  promised,  and  the  creditor  is  honestly  entitled  to  receive  it" 
(open  letter  in  1896  to  Texas  Democrats  by  Hon.  Roger  Q.  Mills). 
Discuss. 

20.  Would  not  the  men  in  the  creditor  class  have  had  different  views 
if  they  had  been  debtors  ? 

21.  Was  the  opposition  to  "cheap  money"  in  New  England  due  to 
superior  honesty  and  morality,  or  to  self-interest  ? 

22.  "K  a  free  silver  bill  becomes  a  law,  a  veteran  who  now  gets  a 
pension  worth  to  him  $4.00  per  month  would  receive  actually 
$2.80,  with  the  chance  of  its  going  down  to  an  actual  value  of 
$2.40.  An  old  soldier  who  is  a  total  physical  wreck  gets  $72.00 
a  month.  If  a  free  silver  bill  passed,  while  he  would  nominally 
get  this  sum,  he  would  really  get  but  $50. 40.  This  coinage  ques- 
tion should  not  be  one  of  party  politics.  It  rises  above  partisan- 
ship. The  honor  of  the  country  is  at  stake.  Its  good  faith  not 
only  to  its  living  soldiers  is  brought  into  question,  but  if  a  so-called 
free  coinage  bill  becomes  law,  the  widows  and  orphans  of  the 
nation's  dead  will  be  robbed  by  the  laws  of  the  land  they  died  to 
save.  The  law  would  work  a  monstrous  wrong,  for  from  the 
moment  it  goes  upon  the  statute  book  it  represents  over 
$45,000,000  per  year  taken  from  the  ex-soldiers,  their  widows, 
and  their  orphans"  (Congressman  Harter  in  a  circular  to  aD 
the  Grand  Army  posts,  1892).    Do  you  agree? 

23.  Upon  what  classes  of  the  community  do  the  evils  of  a  depreciating 
standard  fall  most  heavily  ? 

24.  If  the  value  of  the  dollar  falls  8  per  cent  in  a  year,  how  much  net 
interest  does  a  man  receive  who  buys  bonds  yielding  5  per  cent  ? 

25.  What  was  the  net  return  on  a  4  per  cent  Liberty  bond  purchased 
in  191 7  ?  Was  the  investor  indirectly  pajdng  the  costs  of  the 
war?     (See  chart  on  p.  31.) 

26.  Do  investors  usually  take  into  account  the  shrinkage  in  the  value 
of  the  standard  ? 

27.  If  a  man  "discounts  the  future"  at  the  rate  of  5  per  cent,  would 
he  invest  at  all  when  the  dollar  is  shrinking  rapidly  ? 

28.  Most  educational  and  eleemosynary  institutions  receive  a  large 
portion  of  their  income  from  investments  in  bonds.    In  a  period 


40  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

of  rising  prices  is  it  easy  for  them  to  increase  salaries  and  thus 
offset  the  high  cost  of  living  ?  Is  it  easy  for  them  to  raise  tuition 
sufficiently  to  offset  at  once  the-  shrinkage  in  the  real  return  from 
investments  and  to  increase  salaries  ?    What  is  the  way  out  ? 

29.  An  insurance  company  invests  its  premiums  largely  in  bonds. 
What  is  the  result  during  periods  of  rising  prices  ?  falling  prices  ? 

30.  Do  you  imagine  insurance  companies,  savings  banks,  etc., 
would  shift  investments  to  stocks  during  periods  of  rising  prices  ? 

31.  What  is  meant,  precisely,  by  the  high  cost  of  living?  Does  it 
mean  hard  times?  for  everybody?  If  prices  were  low,  would 
everybody  be  happy  ?    Were  they  in  the  early  nineties  ? 

32.  Is  there  any  means  by  which  the  salaried  and  wage-earning 
classes  may  escape  the  evils  of  rising  prices  ? 

33.  If  prices  should  recede  in  this  after-the-war  period,  what  classes 
will  gain  ?  what  ones  lose  ? 

34.  Indicate  why  a  business  man  might  dislike  falling  prices. 

35.  Why  do  farmers  usually  object  to  falling  prices? 

36.  What  is  the  attitude  of  labor  toward  falling  prices  ? 

37.  Do  you  think  it  possible  that  we  might  have  an  anti-deflation 
movement  at  the  present  period  if  prices  should  decline  ? 

38.  Which  do  you  prefer,  the  high  cost  of  living  or  the  evil  of  fall- 
ing prices  ? 

39.  During  the  war  did  salaried  people  and  those  whose  wages  did 
not  increase  as  fast  as  prices  pay  indirect  taxation  ?  Did  such 
taxation  help  win  the  war  ?    Is  it  a  good  form  of  taxation  ? 

REFERENCES  FOR  FURTHER  READING 

Johnson,  Joseph  French:   Money  and  Currency,  chap.  ii. 
Laughlin,  J.  Laurence:  Principles  of  Money,  chap.  iii. 
Moulton,  Harold  G. :  Principles  of  Money  and  Banking,  Part  I, 
Selection  No.  7. 

Scott,  William  A. :  Money  and  Banking,  chaps,  iii  and  iv. 


CHAPTER  IV 

OTHER  FUNCTIONS  AND  SERVICES 
OF  MONEY 

I.    MONEY  AS  A  MEDIUM  OF  EXCHANGE 

"  Money  is  a  medium  of  exchange. "  This  is  the  definition 
of  money  commonly  found  in  the  dictionaries;  it  is  the  essence 
of  the  layman's  thought  on  the  subject;  and  it  is  the  function 
upon  which  most  emphasis  is  usually  laid  by  writers  on  monetary 
theory.  Treatises  on  money,  indeed,  commonly  begin  with  a 
statement  of  the  inconvenience  of  barter,  or  direct  exchange  of 
one  commodity  for  another,  and  then  proceed  to  show  the 
advantages  of  money  as  a  medium  for  effecting  exchanges. 

The  inconvenience  of  effecting  exchanges  by  means  of 
barter  is  obviously  very  great.  It  is  necessary  for  an  indi- 
vidual who  wishes  to  trade  a  commodity  not  only  to  find  some- 
one who  has  the  precise  commodity  which  he  desires;  he  must 
also  find  someone  who  wishes  the  particular  commodity  that  is 
offered  in  exchange.  And  even  when  two  individuals,  each 
having  a  commodity  desired  by  the  other,  are  brought  together, 
it  is  still  often  impossible  to  effect  an  exchange,  because  the  com- 
modities may  be  of  substantially  different  value.  It  is  of  inter- 
est to  note  that  the  unequal  value  of  bartered  commodities 
has  given  rise  to  the  familiar  practice  of  paying  something 
"to  boot." 

Money  as  a  medium  of  exchange  eliminates  the  inherent 
difficulties  in  barter.  The  seller  disposes  of  his  goods  for 
money,  and  with  the  money  purchases,  at  such  times  and  in  such 
quantities  as  he  desires,  the  goods  which  he  needs. 

This  function  of  money  as  a  medium  of  exchange  really 
divides  barter  into  three  parts,  as  follows:'  "(i)  selling  goods  for 
money,  (2)  keeping  the  money  until  other  goods  are  needed, 

*  F.  M.  Taylor,  Some  Chapters  on  Money,  pp.  14,  16. 

41 


42  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

and  (3)  using  the  money  to  buy  other  goods.  It  is  further 
evident  that  in  these  three  phases,  looked  at  from  the  stand- 
point of  the  man  who  starts  out  with  goods  to  sell,  money 
plays  three  different  parts.  In  the  first,  its  role  is  that  of  a 
thing  which  can  he  obtained  with  any  goods  whatsoever.  In 
the  second,  its  business  is  to  keep — store — this  power  to  obtain 
other  goods.  In  the  third,  its  part  is  that  of  a  thing  which 
can  obtain  any  goods  whatsoever," 

Exchange  makes  possible  large-scale  production.  The  service 
of  money  in  this  connection  is  not  merely  that  it  saves  time  in 
effecting  exchanges.  Of  infinitely  greater  significance  is  the 
fact  that  it  makes  possible  a  specialized  exchange  society,  and 
hence  large-scale  production.  Without  a  medium  of  exchange 
business  transactions  would  have  to  be  of  the  very  simplest 
nature.  Trading  would  have  to  be  confined  to  local  areas,  and 
production  would  have  to  be  conducted  on  a  small-scale  basis. 
In  fact,  without  a  medium  of  exchange  the  modern  system  of 
specialized  production  and  exchange,  by  means  of  which 
industrial  establishments  are  enabled  to  produce  in  tremen- 
dous quantities  at  a  low  cost  per  unit,  and  to  seU  their  products 
throughout  the  civiUzed  world,  would  be  out  of  the  question. 

n.    MONEY  AS  A  STORE  OF  VALUE 

Before  the  development  of  modern  banking  institutions 
and  the  system  of  credit  by  means  of  which  funds  may  be 
safely  invested  in  productive  enterprises,  wealth  was  usually 
stored  up  for  future  use  by  means  of  hoarding  the  precious 
metals.  Gold  and  silver,  comprising  large  value  in  small  bulk, 
and  being  of  universal  acceptability  in  exchange  for  commodities, 
constituted  the  best  means  available  for  accumulating  wealth  for 
old  age;  hence  the  hidden  treasures  of  history  and  fable.  While 
under  modern  conditions  money  is  characteristically  held  for  a 
brief  interval,  as  noted  above,  it  is  not  often  stored  in  the  sense 
of  being  hoarded;  it  is  invested  instead  through  the  machinery 
provided  by  banking  institutions. 


FUNCTIONS  AND  SERVICES  OP  MONEY  43 

m.    THE  USE  OF  MONEY  IN  PRODUCTION 

When  money  is  spoken  of  as  a  medium  of  exchange,  one 
usually  has  in  mind  the  exchange  of  consumers'  goods.  For 
convenience  of  exposition,  economic  treatises  have  commonly 
been  divided  into  four  parts,  devoted  respectively  to  con- 
sumption, production,  exchange,  and  distribution.  Money  is 
treated  under  exchange,  and  its  chief  function  is  usually  regarded 
as  that  of  effecting  the  exchange  of  goods  that  have  already 
been  produced  and  are  in  the  market  awaiting  transfer  to 
the  hands  of  those  who  are  to  consume  them. 

The  common  failure  of  writers  on  money  to  call  attention 
to  the  part  that  money  plays  in  effecting  the  exchange,  on  the 
one  hand  of  personal  and  professional  services,  including  labor, 
and  on  the  other  of  capital  goods,  raw  materials,  and  partly 
finished  products  in  the  processes  of  capitalistic  production 
is  no  doubt  attributable  to  the  fact  that  monetary  theory  was 
first  worked  out  at  a  time  when  the  volume  of  personal  and 
professional  services  was  negligible,  when  the  producing 
and  manufacturing  process  was  largely  conducted  on  a  non- 
capitalistic  basis,  and  when  in  the  main  it  was  only  completed 
consumers'  goods  that  were  exchanged  through  the  use  of 
money.  In  emphasizing  only  the  exchange  of  produced  goods 
modern  writers  on  money  have  therefore  merely  followed 
tradition. 

But  if  one  is  to  appreciate  fully  the  significance  of  money 
under  a  capitalistic  industrial  regime  it  is  necessary  to  consider 
the  part  that  it  plays  in  the  productive  as  well  as  in  the  exchange 
process.  Exchange  of  consumers'  goods  is  not  to  be  excluded; 
but  the  role  of  money  in  getting  goods  ready  to  be  exchanged 
as  completed  products  is  to  be  included. 

Modern  business  is  almost  universally  conducted  through  the 
use  of  money.  Under  the  conditions  of  modern  capitalistic 
industry  money  is  utilized  in  connection  with  every  stage  of 
the  productive  process.  With  money  the  manufacturer  pur- 
chases the  materials  needed  for  the  construction  of  his  plant; 
with  money  he  hires  laborers  to  build  the  factory;  with  money 


44  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

he  employs  an  administrative  staff  to  manage  the  business;  and 
with  money  he  purchases  the  materials  and  supplies,  together 
with  the  necessary  labor  force  required  to  operate  the  business. 
In  a  similar  way  the  farmer,  under  modem  conditions,  uses 
money  in  connection  with  every  phase  of  his  operations.  So 
also  with  the  producers  of  raw  material,  whether  in  the  form  of 
coal,  ores,  lumber,  what  not.  While  from  one  point  of  view  the 
wholesaler  and  retailer  are  engaged  in  distributing  goods  that 
have  already  been  produced,  from  another  they  are  occupied 
in  carrying  out  certain  essential  parts  of  the  productive  process. 
Transportation  agencies  also  use  money  in  connection  with 
every  phase  of  their  business  operations. 

In  short,  practically  the  entire  productive  process  is  nowa- 
days organized  and  operated  through  the  use  of  money.  All 
the  capital  used  in  modem  business  is  expressed  in  terms  of 
money,  and  indeed  it  is  initially  in  the  form  of  currency.  The 
economist  defines  capital  as  concrete  material  goods  used  in 
producing  other  goods;  while  the  business  man  usually  thinks 
of  capital  as  money,  or  funds,  available  for  business  purposes. 
This  is  primarily  due  to  the  fact  that  subscriptions  to  shares  of 
stock  or  to  bonds  are  received  in  the  form  of  liquid  funds, 
and  that  with  the  "fixed  capital"  thus  raised  the  business 
man  constructs  and  equips  his  plant.  Similarly,  "working 
capital  usually  consists  initially  of  funds  in  the  till  or  in  the 
bank,  derived  either  from  the  subscriptions  of  partners  or  share- 
holders or  from  bank  loans.  With  these  liquid  funds  the  busi- 
ness man  hires  his  labor  and  purchases  the  materials  and 
supplies  required  in  the  producing,  manufacturing,  or  marketing 
process.  With  "Uquid  funds,"  or  money,  the  factors  of  pro- 
duction are  thus  assembled  and  organized  into  a  going  concern. 

It  is  therefore  not  surprising  that  the  business  man  should 
usually  think  of  capital  in  monetary  terms.  Upon  reflection 
he  will  realize,  of  course,  that  money  is  only  a  handmaiden  of 
production,  that  the  things  with  which  wealth  is  really  created 
are  concrete  capital  instruments  in  the  form  of  machines,  build- 
ings, etc.  On  the  other  hand,  while  the  econornist  is  warranted 
in  laying  emphasis  upon  the  material  instruments  of  production, 


FUNCTIONS  AND  SERVICES  OF  MONEY  45 

he  must  recognize,  if  he  is  to  appraise  successfully  the  part  that 
money  plays  in  a  capitalistic  society  that  without  the  use  of 
liquid  funds  or  monetary  instrimients  capital  goods  and  labor 
cannot  be  assembled  and  put  to  productive  work/ 

IV.     THE  ROLE  OF  MONEY  IN  WAR 
FINANCE 

A  consideration  of  the  part  that  money  plays  in  time  of 
war  will  serve  as  a  convenient  means  of  revealing  its  significance 
in  ways  other  than  those  that  have  already  been  discussed. 
,  Napoleon  once  said  that  three  things  are  necessary  if  a  war  is  to 
be  waged  successfully:  money,  more  money,  and  still  more 
money.  How  often  during  the  recent  Great  War  we  were  told 
that  money  provided  the  sinews  of  battle,  that  cash  and  credit 
would  insure  the  victory.  Let  us  consider  precisely  how  money 
is  of  service  in  time  of  war. 

In  a  war  between  two  nations  only,  with  the  rest  of  the 
commercial  world  unaffected,  money  is  of  paramount  impor- 
tance. With  money  in  hand,  the  government  can  purchase 
the  war  supplies  needed  from  neutral  countries.  Money  thus 
buys  the  real  sinews  with  which  wars  are  waged.  Before  the 
entrance  of  the  United  States  into  the  Great  War,  for  example, 
England  and  France  purchased,  with  money,  great  quantities 
of  war  supplies  from  the  United  States.  And  if  these  countries 
could  have  increased  their  total  supplies  of  money,  they  could 
have  continued  to  purchase  materials  from  the  neutral  world, 
to  an  extent  Kmited  only  by  the  producing  capacity  of  the 
neutral  nations. 

But  under  the  conditions  that  existed  at  the  time  the 
United  States  entered  the  Great  War,  it  was  impossible  for  us  to 
use  money  to  any  great  extent  in  buying  goods  from  any  other 
nation,  for  the  simple  reason  that  almost  the  entire  commercial 
world  was  then  at  war.    With  his  money.  Uncle  Sam  could  buy 

'  From  the  viewpoint  of  productive  requirements,  the  supply  of  money 
is  not  always  a  matter  of  indifiference.  "Capital"  in  the  form  of  funds  is 
sometimes ' '  scarce ' '  and  sometimes  ' '  plentiful. ' '  The  amount  available  may 
have  an  important  bearing  upon  productive  activities.     See  chap,  xxiii. 


46  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

war  supplies  only  from  himself.  It  may  be  noted  that,  in  con- 
sequence of  the  blockade,  Germany  had  been  in  this  condition 
from  almost  the  beginning  of  the  war. 

It  was  often  said  early  in  the  struggle  that  as  long  as  Ger- 
many kept  all  of  her  money  within  the  country,  she  would  never 
be  lacking  in  funds  with  which  to  wage  the  war;  and,  similarly, 
many  people  thought  that  as  long  as  the  United  States  had 
great  quantities  of  gold  and  other  forms  of  currency,  we  should 
surely  be  in  a  position  to  wage  war  effectively.  What  was 
not  usually  appreciated  was  that  money  is  only  a  means  to  an 
end,  and  that  the  total  quantity  available  is  of  less  importance 
than  the  way  in  which  it  is  used  by  the  nation. 

There  was  much  apparent  mystery  in  the  year  191 7  as  to 
how  our  government  could  raise  some  twenty  billions  of  dollars 
when  there  was  only  $4,702,130,941  of  currency  in  the  country. 
The  answer  is  that  when  we,  the  people,  turn  funds  into  the 
Treasury,  the  Secretary  promptly  buys  the  needed  supplies 
from  us,  the  people.  Funds  are  thus  merely  passed  through  the 
Treasury  Department  in  successive  installments,  giving  purchas- 
ing power  while  there,  but  passing,  in  the  act  of  purchasing  the 
supphes  required,  back  again  into  the  channels  of  industry. 
Twenty  billions  could  thus  be  raised  in  a  single  year  by 
having,  say,  four  hundred  milUons  pass  through  the  Treas- 
ury Department  once  a  week  for  fifty  weeks.  In  fact,  how- 
ever, "actual  gold  or  actual  money  is  not  used  to  any  very 
great  extent;  credit  instruments  in  the  form  of  checks  and 
drafts  are  the  means  most  generally  employed  in  making 
payments. 

Industrial  mobilization  is  dtcomplished  by  monetary  means. 
With  money  in  hand,  the  government  seeks  to  induce  the 
production  of  war  supplies  by  means  of  >n  offer  of  high  prices 
to  business  men  engaged  in  production.  It  is  necessary  to 
offer  high  prices  because  it  is  necessary  to  effect  a  substantial 
shifting  of  production  if  the  vast  quantities  of  war  supplies 
required  are  to  be  forthcoming.  This  shifting  of  industry 
from  ordinary  lines  to  the  production  of  war  suppUes  gives  rise 
to  many  unusual  risks.    The  price  offered  by  the  government 


FUNCTIONS  AND  SERVICES  OF  MONEY  47 

must  therefore  be  high  enough  to  cover  all  costs  incident  to 
the  transition  into  the  war  business,  the  losses  due  to  high  costs 
of  operation  while  engaged  in  the  manufacture  of  war  supplies, 
and  finally  the  losses  incident  to  the  transition  back  to  peace- 
time industry  after  the  war.  The  price  and  profit  system, 
expressed  in  terms  of  the  pecuniary  unit  of  calculation  and  made 
efifective  by  a  diversion  of  a  portion  of  the  money  supply  of  the 
nation  to  the  government,  is  thus  the  means  by  which  the  nation 
secures  the  readjustment  of  industry  necessary  to  the  successful 
prosecution  of  the  war.^ 

Private  consumers  compete  against  the  government  for  pro- 
ductive energy.  The  general  public  may  either  aid  or  deter  the 
government  in  this  process,  depending  upon  the  way  in  which 
people  employ  the  monetary  income  at  their  disposal.  If  the 
wages  and  profits  of  industry  are  freely  used  in  the  purchase  of 
goods  for  ordinary  consumption,  this  spending  results  in  a  direct 
competition  with  the  government  for  the  productive  energy  of 
the  nation.  The  competition  of  private  buyers  of  ordinary  com- 
modities is  usually  effective  against  the  government's  competi- 
tion without  a  proportionate  bidding  up  of  prices,  for  the  reason 
that  business  is  adjusted  to  the  production  of  commodities  for 
ordinary  consumption,  and  hence  the  risks  of  industry  are  less 
than  is  the  case  where  shifting  to  war  production  is  required. 
It  was  because  of  this  competition  between  private  buyers  and 
the  government  for  a  limited  supply  of  social  energy  that  the 
argument  for  "business  as  usual"  was  unsound;  and  it  was 
because  of  this  that  the  governments  of  all  the  belligerent 
nations  urged  the  most  rigid  economy  on  the  part  of  the  general 
public. 

It  will  be  seen  from  the  foregoing  that  the  chief  function  of 
money  in  time  of  war  is  to  facilitate  the  proper  direction  of 
industrial  energy,  to  shift  production  from  less  essential  to 

'  While  this  method  of  financial  inducement  was  the  chief  means  relied 
upon  early  in  the  Great  War,  it  was  later  largely  supplanted  by  methods  of 
priority  in  the  use  of  raw  materials,  transportation,  etc.,  and  in  some 
countries  by  actual  conscription  of  industrial  establishments  for  war  pur- 
poses. Taxation  may  also  be  made  to  play  an  important  part  in  forcing 
economic  readjustments. 


48  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

more  essential  enterprises.  This  is  not  to  say,  however,  that 
the  total  quantity  of  money  available  in  time  of  war  is  a  matter 
of  entire  indifference;  for  the  necessary  shifting  of  energy  can, 
as  a  practical  matter,  be  secured  more  quickly  if  there  is  an 
increase  in  the  total  quantity  of  monetary  instruments.  Dis- 
cussion of  this  phase  of  the  question  must,  however,  here  be 
passed  by,  since  it  would  involve  a  study  of  the  problem  of 
reorganizing  the  entire  economic  system  to  meet  the  tyrannical 
requirements  of  war. 

V.  THE  ROLE  OF  MONEY  IN  PEACE  FINANCE 

A  consideration  of  the  way  in  which  money  is  used  in  time 
of  war  to  effect  a  redistribution  of  social  energy  is  a  convenient 
point  of  departure  for  a  consideration  of  a  similar  service 
performed  by  money  in  distributing  productive  energy  in 
ordinary  times.  As  we  have  already  seen,  the  work  of  society 
is  now  largely  organized  through  the  use  of  money.  The 
greater  part  of  this  work  is  under  the  direction  of  private  busi- 
ness men  in  search  of  profits.  Some  of  it,  however — and  the 
amount  is  constantly  increasing — is,  in  peace  as  well  as  in 
war,  under  the  control  of  government.  Our  government,  for 
instance,  provides  funds  for  education,  charitable  organiza- 
tions, public  health,  highways  and  parks,  national  defense,  and 
a  large  amoimt  of  scientific  and  social  investigation  in  connection 
with  such  departments  as  agriculture,  the  interior,  commerce, 
labor,  etc.  It  also  conducts  the  postal  service;  while  in  most 
countries  of  the  world  the  great  transportation  systems  have 
long  been  imder  governmental  direction. 

Society  secures  the  prosecution  of  governmental  enterprises 
by  diverting  funds,  through  taxation  and  bond  issues,  from 
individuals,  who  would  be  spending  them  for  ordinary  con- 
sumptive purposes,  to  the  government,  where  they  are  available 
for  hiring  the  necessary  labor  supply  and  for  purchasing  the 
required  materials  for  the  enterprises  in  question.  Money  is 
the  means  by  which  the  government  is  enabled  to  bid  for  a 
diversion  of  our  productive  energy  into  these  channels. 


FUNCTIONS  AND  SERVICES  OF  MONEY  49 

The  distribution  of  productive  energy  is  effected  by  the  use  oj 
money.  In  a  similar  way,  money  is  the  means  by  which  the  sup- 
ply of  social  energy  is  distributed  among  the  various  forms  of 
private  enterprise.  We  have  already  seen  (chapter  ii)  that  it 
is  the  relative  profits  that  are  to  be  obtained  in  different  lines 
of  industry  that  determine  the  distribution  of  social  energy 
among  those  lines.  It  only  remains  to  note  that  a  demand  for 
a  particular  line  of  goods  sufficient  to  induce  energy  to  enter 
that  line  is  made  effective  by  the  use  of  monetary  expenditures 
in  the  market;  and  that  money  is  the  means  by  which  the 
entrepreneur  entering  that  line  bids  in  the  labor  and  com- 
modity markets  for  the  productive  energy  which  he  requires 
in  order  to  produce  the  goods  in  question. 

Not  only  is  money  the  instrumentality  through  which 
energy  is  distributed  among  the  different  industries  engaged  in 
the  production  of  consumers'  goods;  it  is  also  the  means  by 
which  the  energy  of  society  is  apportioned  between  the  produc- 
tion of  consumers'  goods  and  the  production  of  additional  capital 
goods.  The  creation  of  additional  capital  goods  requires  the 
borrowing  of  liquid  capital  in  the  form  of  monetary  instruments. 
If  society  at  any  given  time  utilized  all  of  its  wages  and  profits 
for  the  purchase  of  consumers'  goods,  no  funds  would  be  avail- 
able for  the  uses  of  entrepreneurs  who  desire  to  create  additional 
capital  goods.  Saving  of  a  portion  of  the  annual  income  is 
necessary  if  a  sufficient  volume  of  funds  is  to  be  available  in 
the  hands  of  investment  banking  institutions  for  the  uses  of 
capitalists  who  are  seeking  to  develop  new  enterprises. 

On  the  other  hand,  every  industry  which  is  engaged  in 
turning  out  consumption  goods  uses  monetary  instruments 
(working  capital)  as  the  means  of  securing  the  necessary 
social  energy.  There  is  thus  a  competition  for  the  supply  of 
monetary  instruments  between  those  who  are  engaged  in  the 
production  of  new  capital  goods  and  those  who  are  engaged  in  the 
creation  of  additional  quantities  of  consumers'  goods.  This 
competition  for  the  available  supplies  of  monetary  instruments 
and  the  consequent  apportionment  of  social  energy  between  the 
creation  of  capital  goods  and  the  creation  of  consumers*  goods 


so  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

involves  some  of  the  most  intricate  and  important  problems  in 
the  entire  field  of  economic  organization.  Our  present  purpose, 
however,  is  merely  to  point  out  the  fact  that  money  plays  an 
important  role  in  the  apportionment  of  our  productive  energy. 

QUESTIONS  FOR  DISCUSSION 

1.  "With  barter  there  must  be  a  'double  coincidence*  in  order  to 
effect  an  exchange."    Explain  by  a  concrete  illustration. 

2.  Mention  as  many  cases  as  you  can  of  the  use  of  barter  at  the 
present  time.  Is  money  not  used  as  a  basis  of  reckoning,  even  in 
these  cases  ? 

3.  Precisely  what  is  meant  by  the  function  of  a  medium  of  exchange? 

4.  Discuss  the  relation  of  a  medium  of  exchange  to:  (o)  industrial 
specialization;  (b)  territorial  specialization;  (c)  the  size  of  the 
business  unit ;  (d)  the  efficiency  of  production. 

5.  Do  you  think  that  money  is  more  important  as  a  medivun  of 
exchange  than  (o)  as  a  pecimiary  unit  of  calcidation;  (b)  as  a 
standard  of  deferred  payments? 

6.  Is  the  use  of  money  as  a  store  of  value  really  a  monetary  function  ? 
Is  it  a  function  separate  and  distinct  from  that  of  a  medium  of 
exchange  ? 

7.  When  money  is  invested,  is  it  not  still  serving  as  a  store  of  value  ? 

8.  Does  the  business  man  ordinarily  think  of  money  as  a  medium 
of  exchange  ?  What  would  he  be  likely  to  say  the  fimction  of 
money  in  business  is  ? 

9.  Is  it  only  goods  ready  to  be  transferred  to  ultimate  consumers 
whose  exchange  is  effected  by  the  use  of  money  ? 

10.  Do  you  regard  the  transfer  of  services  under  modem  conditions 
as  relatively  unimportant?  Do  you  regard  the  payment  of 
money  wages  as  an  exchange  funcrion  ? 

11.  The  organization  of  a  business  requires  the  raising  of  a  certain 
amount  of  fixed  capital.  Immediately  speaking,  this  fixed  capital 
is  in  the  form  of  liquid  funds  or  monetary  instruments.  Are  not 
these  funds,  however,  merely  used  as  a  means  of  procuring  goods 
that  have  aheady  been  produced  ? 

12.  Every  business  also  requires  "working"  or  "operating"  capital. 
Immediately  speaking,  this  capital  is  in  the  form  of  Uquid  funds 
or  monetary  instruments.  Are  these  funds  always  used  as  a 
means  of  procuring  goods  which  have  previously  been  produced  ? 


FUNCTIONS  AND  SERVICES  OF  MONEY  51 

13.  Suppose,  with  the  liquid  capital  possessed  by  a  business,  immi 
grants  are  hired  to  come  to  the  United  States  and  are  set  to  work 
digging  coal  or  ore  out  of  the  ground:  Was  this  money  used 
merely  in  transferring  goods?  Suppose  men  otherwise  unem- 
ployed are  put  to  work  producing  raw  materials  or  building  a 
factory:  Does  this  involve  merely  a  transfer  of  existing  wealth? 

14.  In  time  of  war  money  is  regarded  as  a  prime  requisite.  Can  it 
be  used  in  firing  at  the  enemy?  Can  it  be  used  to  purchase 
supplies  in  foreign  countries  ? 

15.  What  is  the  precise  function  of  money  in  connection  with  war 
finance  under  conditions  where  goods  cannot  be  secured  from 
abroad  ? 

[6.  Could  industrial  mobilization  in  fact  be  effected  without  the 
use  of  money  ?  Could  the  motive  force  to  industrial  mobilization 
be  something  besides  monetary  profits?  If  so,  what?  Would 
money  stiU  be  used  under  these  conditions  ? 

17.  Do  you  think  it  is  true  that  private  spenders  compete  directly 
against  the  government  in  time  of  war  ?  What  are  the  responsi- 
bilities of  private  consumers  under  such  circumstances  ? 

18.  In  ordinary  times  do  different  groups  of  individuals  compete 
against  each  other  for  the  use  of  society's  productive  energy  ? 

TQ.  What  determines  the  proportion  of  our  social  energy  that  is 
devoted  to  the  production  of  food  and  other  necessities  of  life  ? 
Does  this  coincide  with  the  principle,  "Necessities  for  all  before 
luxuries  for  any  "  ? 

20.  "The  greater  the  differences  in  relative  incomes  of  different 
classes,  the  larger  tends  to  be  the  percentage  of  our  social 
energy  which  is  diverted  to  the  production  of  luxuries."  Do 
you  agree  ? 

21.  At  the  present  time  the  masses  of  the  people  in  Europe  have  very 
low  incomes.  Certain  classes  which  were  favorably  placed  in 
the  industrial  system  during  the  war  have  large  incomes.  The 
latter,  by  extravagant  expenditure,  are  inducing  the  production 
of  luxuries  and  other  dispensable  commodities.  The  poverty  of 
the  masses  makes  the  production  of  additional  quantities  of 
necessaries  of  life  relatively  unprofitable.  Do  you  think  the 
profit-making  system  is  working  well  under  present  conditions  ? 

22.  In  the  cases  under  discussion  money  is  serving  a  double  function: 
(o)  as  a  basis  for  computing  profits;  (b)  as  the  means  by  which 
labor  and  capital  are  attracted  into  the  more  profitable  lines  of 
business.    Do  you  agree  ? 


52  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

23.  The  number  of  enterprises  that  are  being  undertaken  by  govern- 
ments— national,  state,  and  local — ^has  been  constantly  increas- 
ing in  recent  years.  Are  there  important  social  measures  which 
must  be  held  in  abeyance  because  they  cannot  be  financed? 
Why  is  it  that  they  cannot  be  financed  ? 

24.  Each  year  an  adequate  proportion  of  the  social  energy  of  society 
should  be  devoted  to  the  replenishment  and  extension  of  the 
capital  supply.  How  is  this  apportionment  of  our  productive 
energy,  as  between  the  creation  of  capital  and  consumptive 
goods,  effected  under  a  pecvmiary  system  ? 

25.  Does  spending  compete  against  saving? 

26.  Precisely  what  is  meant  by  " saving  "  ?  Has  saving  been  effected, 
in  fact,  as  soon  as  money  income  has  been  placed  in  a  bank  or 
invested  in  securities  ? 

27.  What  determines  the  percentage  of  the  monetary  income  annually 
received  by  society  that  is  saved  and  that  is  spent  for  consumptive 
goods?  Is  this  apportionment  necessarily  worked  out  in  the 
interests  of  long-nm,  general  welfare  ? 

REFERENCES  FOR  FURTHER  READING 

Holdsworth,  John  Thom:  Money  and  Banking,  chap.  i. 
Johnson,  Joseph  French:  Money  and  Currency,  chap.  L 
Laughlin,  J.  Laurence:  Principles  of  Money,  pp.  15-22. 
Moulton,  Harold  G. :  Principles  of  Money  and  Banking,  Part  I, 
Selections  Nos.  4  and  5. 

Scott,  William  A.:  Money  and  Banking,  pp.  6-23. 


CHAPTER  V 

THE  PECUNIARY  SYSTEM  AND  ECONOMIC 
AND  SOCIAL  STANDARDS 

From  the  very  beginning  of  the  capitalistic  regime,  under 
which,  as  we  have  seen,  practically  all  productive  and  trading 
operations  are  carried  on  through  the  intermediation  of  currency 
and  find  expression  in  monetary  terms,  there  has  been  a  general 
misunderstanding  of  the  social  significance  of  money.  Consti- 
tuting a  general  fund  of  purchasing  power — a  veritable  key 
to  things  desired — ^money  is  by  many  people  regarded  as  an 
end  in  itself,  the  summum  honum  of  human  endeavor;  while 
by  many  more  it  is  deemed  at  least  a  very  superior  form  of 
wealth,  a  plentiful  or  scanty  supply  of  which  renders  a  nation 
rich  or  poor,  powerful  or  impotent.  The  confusion  of  money 
with  welfare  has,  moreover,  been  responsible  for  many  ill- 
judged  movements  for  social  reform.  Indeed,  so  vital  an 
influence  has  money  been  in  the  evolution  of  industrial  society 
that  Alexander  Delmar,  who  has  doubtless  given  more  study 
to  the  origin  and  development  of  monetary  systems  than  any 
other  writer,  suggests  that  the  history  of  money  is  the  history 
of  civilization. 

While  this  view  is  not  accepted  by  most  writers,  all  are 
nevertheless  agreed  that  money  has  played  a  r61e  of  enormous 
importance  in  the  affairs  of  men.  More  articles  and  books  have 
been  written  and  there  has  been  more  discussion  on  the  subject 
of  money  than  on  any  other  in  the  entire  realm  of  political 
economy.  At  the  same  time  the  various  controversies  have 
developed  more  extreme  enthusiasm  and  greater  bitterness  of 
denunciation  than  those  in  any  other  field.  In  the  somewhat 
exaggerated  phraseology  of  Mr.  Bryan,  "Brother  has  been 
arrayed  against  brother,  father  against  son.  Warmest  ties  of 
love,  acquaintance  and  association  have  been  disregarded; 

Si 


54  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

old  leaders  have  been  cast  aside  ....  and  new  leaders  have 
sprung  up  to  give  direction  to  the  cause  of  truth." 

I.    MONETARY  EVALUATION  AND  SOCIAL  IDEALS 

The  extraordinary  importance  that  has  been  attached  to 
money  throughout  the  ages  may  be  appreciated  by  reference  to 
the  following  classical  quotations.  They  also  suggest  the 
influence  of  the  pecuniary  calculus  upon  ethical  standards: 

Horace:  Make  money,  money,  man; 

Well,  if  so  be, — if  not,  which  way  you  can. 
Timocles:  Money's  the  life  and   soul  of  mortal  man.    Who 

has  it  not,  nor  has  acquired  it, 

Is  but  a  dead  man,  walking  'mongst  the  quick. 
Milton:  Money  brings  honor,  friends,  conquest,  and  realms. 

Pope:  There  London's  voice,  'Get  money,  money  still, 

And  then  let  virtue  follow  if  she  will.' 
Tennyson:  But  the  jingling  of  the  guinea  helps  the  hurt  that 

honor  feels. 
Paul  of  Tarsus:  For  the  love  of  money  is  the  root  of  all  evil. 

The  perversion  of  social  ideals  that  has  attended  the  develop- 
ment of  a  pecuniary  system  is  well  expressed  by  Professor 
Davenport  in  the  following  language: 

More  and  more,  and  more  and  more  exclusively,  and  over  an  ever- 
widening  field  of  human  effort,  hmnan  interests  and  desires  and 
ambitions  fall  under  the  common  denominator  of  money.  Doubtless 
many  of  the  best  things  in  life  do  not  get  bought  and  sold.  Some 
of  them  are  not  exchangeable;  and  not  all  things  that  could  be 
transferred  are  men  weak  enough  to  sell  or  other  men  strong  enough  to 
buy.  Not  every  man  has  his  money  price.  But  most  good  things 
do,  in  greater  or  less  degree,  submit  to  the  money  appraisal.  Health 
is  easier  for  him  who  can  take  his  ease  and  who  has  the  wherewithal 
to  pay  for  good  foods  and  medicines,  to  travel,  to  employ  good  nurs- 
ing, and  to  command  capable  physicians  and  efficient  surgeons. 
And  in  their  degree,  also,  love  and  pity  and  respect  and  place  are 
bought  and  sold  upon  the  market.  It  takes  a  goodly  number  of 
dollars  to  get  a  child  safely  born,  and  even  more  dollars  to  achieve  for 
one's  self  a  respectable  burial.  Much  money  is  power  over  many 
things.  Money  is  the  standard  of  value  in  the  sense  that  all  values  of 
all  exchangeable  things  are  expressed  in  terms  of  it.    And  this  holds, 


PECUNIARY  SYSTEM  AND  ECONOMIC  STANDARDS      55 

not  only  of  all  commodities  and  services,  but  of  all  incomes  and 
of  all  capitals.  The  capital  of  a  banking  house,  or  a  factory,  or  a 
railroad  company  is  not  a  congeries  of  tangible  things,  but  a  pecuniary 
magnitude — so  many  dollars.  All  economic  comparisons  are  made 
in  money  terms,  not  in  terms  of  subsistence,  or  of  beauty,  or  of  artistic 
merit,  or  of  moral  deserving.  This  same  standard  tends  to  become 
also  the  test  and  measure  of  human  achievement.  Men  engage  in 
business,  not  solely  to  earn  a  livelihood,  but  to  win  a  fortune  in  a 
pecuniary  sense.  To  win  by  this  money  test  is  to  certify  one's 
self  tangibly  and  demonstrably  as  having  scored  in  the  most  wide- 
spread and  absorbing  of  competitions.  Is  one  a  great  artist — what 
do  his  pictures  sell  for?  Or  what  is  the  income  of  this  leading 
advocate?  or  of  that  famous  singer?  How  great  are  the  author's 
royalties  ?  The  pecuniary  standard  tends  to  be  carried  over  into  non- 
pecuniary  fields. 

It  is  almost  past  belief  how  far  both  in  degree  and  in  direction 
money  valuations  pervade  all  our  thinking.  Cheapness  is  prone  to 
be  synonymous  with  ugliness,  richness  with  beauty,  elegance  with 
expensiveness.  No  one  can  tell  for  himself  where  the  really  aesthetic 
begins  and  the  sheer  pecuniary  ends.  In  the  field  of  morals,  also, 
the  so-called  cash-register  conscience  is  an  actual  thing.  And  one 
might  go  still  further  and  note  that  almost  all  great  political  issues, 
and  almost  all  absorbing  social  problems,  and  almost  aU  international 
complications,  rest  upon  a  pecuniary  basis.  Our  national  problems 
are  tariff,  labor  unions,  strikes,  money,  trusts,  banking,  currency, 
railroads,  conservation  of  resources,  shipping,  taxation.  Success 
in  elections,  in  the  selection  of  senators,  in  the  making  of  laws,  and 
in  the  selection  of  judges  is  prone  to  be  desired  for  financial  ends 
and  to  be  decided  by  pecuniary  means.  Diplomatic  complications 
hinge  upon  trade  connections,  the  open  door,  fisheries  and  sealeries, 
colonies  for  markets,  and  spheres  of  influence  for  trade.  Navies 
are  trade  guardians  and  trade  auxiliaries.  Eliminate  from  local 
poHtics  the  influence  of  the  public-service  corporation,  of  the  con- 
tractor, and  of  the  seekers  for  special  pecuniary  privileges,  and  what 
is  left  of  the  municipal  problem  will  be  mostly  the  pecuniary  nexus 
of  the  slum  with  the  ballot  box,  of  the  saloon  with  the  police  system, 
and  of  saloon  and  slum  and  brothel  with  the  city  hall.* 

The  system  of  pecuniary  evaluation  also  tends  to  substantial 
conservatism  in  the  matter  of  social  progress.     All  people  who 
*  From  The  Economics  of  Enterprise^  pp.  23-24. 


S6  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

are  in  possession  of  monetary  incomes  hesitate  to  see  social  insti- 
tutions, upon  the  stability  of  which  depends  the  certainty  of  their 
incomes,  disarranged  by  either  political  or  industrial  changes. 
Vested  interests  which  find  their  expression  in  pecuniary  terms 
stand  as  a  bar  sinister  to  social  progress.  Even  labor  has 
generally  been  induced  to  resist  change  because  change  usually 
iuvolves,  immediately  speaking,  a  sacrifice  of  wages.  Short- 
run  pecuniary  needs  usually  bulk  larger  in  the  laboring  man's 
horizon  than  long-run  gains,  either  to  himself  or  to  society  as  a 
whole. 

Nearly  everywhere,  indeed,  the  price  system  tends  to 
emphasize  the  short-  rather  than  the  long-run  point  of  view. 
Obsolete  and  ineflScient  methods  or  institutions  persist  long 
after  it  is  clear  that  weKare  would  be  distinctly  promoted  were 
they  supplanted  by  others.  Natural  resources  are  ruthlessly 
exploited  during  a  few  brief  years,  leaving  to  future  generations 
a  depleted  national  heritage — ^merely  because  it  pays  best  to 
mine,  or  lumber,  or  farm  without  thought  of  the  distant  morrow. 
Human  beings,  also,  are  at  times  driven  at  an  exhausting  pace 
and  at  others  denied  the  opportunity  of  earning  a  Hvelihood,  in 
order  that  a  maximum  of  monetary  profits  may  result  for 
those  who,  in  the  evolution  of  industrial  society,  have  come  to 
direct  the  machinery  of  modern  production.' 

n.    THE  CONFUSION  OF  MONEY  WITH  WEALTH 

The  importance  that  individuals  in  a  pecuniary  society 
necessarily  attach  to  their  monetary  incomes  lies  at  the  basis  of 
the  prevailing  idea  that  the  quantity  of  money  possessed  by  a 
nation  is  always  of  paramount  importance.  If  the  more  money 
an  individual  has  the  wealthier  he  is,  why  is  it  not  also  true  that 
the  greater  the  quantity  of  money  within  a  nation  the  richer  is  the 
nation  ?  This  belief  that  nations,  like  individuals,  are  well-off  in 
proportion  to  the  amount  of  their  wealth  or  income  as  expressed 
in  monetary  terms  lies  at  the  basis  of  most  of  the  monetary 

*  For  an  exposition  of  this  phase  of  the  modem  pecuniary  system  see 
chap,  xxiii. 


PECUNIARY  SYSTEM  AND  ECONOMIC  STANDARDS      57 

controversies  of  the  past,  among  which  may  be  mentioned  the 
cheap  money  experiments  of  colonial  days  and  the  greenback 
and  free  silver  panaceas  of  our  later  history.  Indeed,  more  or 
less  continuously  throughout  American  history  there  has  been 
a  persistent  complaint  that  our  economic  iUs  are  largely  attribut- 
able to  an  insufficient  quantity  of  money. 

Professor  Bullock  tells  us  that  a  review  of  the  currency 
history  of  America  reveals  that  "a  strong  movement  in  favor 
of  cheap  currency  has  existed  continuously  in  this  country 
from  the  earliest  period  of  colonization;  ....  back  of  all 
the  strivings  for  an  inexpensive  medium  of  exchange,  each 
generation  of  our  people  has  always  heard  the  complaint  that 
our  supply  of  money  has  been  insufficient."  And  Adam  Smith 
wrote  in  1776  that  "no  complaint  is  more  common  than  that 
of  a  scarcity  of  money."  John  Witherspoon,  writing  in  Revo- 
lutionary days,  points  out  that  if  those  persons  who  perpetually 
cry  for  a  larger  volume  of  gold  and  silver  read  the  Scriptures 
"they  may  there  learn  that  in  Solomon's  time,  the  silver  was 
plentiful  as  stones  in  Jerusalem";  but  that  silver  was  so 
plentiful  that  "it  was  nothing  accounted  of  in  the  days  of 
Solomon." 

The  mercantilist  philqsophy  rests  on  confused  ideas  about 
money.  The  belief  in  the  potency  of  much  money  is  the  princi- 
pal basis  of  the  pohcy  known  as  mercantihsm,  a  doctrine  which 
flourished  most  extensively  in  the  seventeenth  and  eighteenth 
centuries  but  still  survives  in  the  belief  that  an  excess  of  exports 
over  imports  and  a  consequent  flow  of  gold  into  a  country  is  at 
all  times  and  under  all  circumstances  distinctly  advantageous. 
The  doctrine  of  mercantilism,  it  is  true,  was  linked  up  with  ambi- 
tious programs  for  national  supremacy,  to  be  attained  through 
the  diversification  of  industry  and  particularly  through  the 
development  of  manufactmre;  and  it  was  apparently  instigated 
by  manufacturing  and  producing  interests  with  something  to 
gain  personally  as  a  result  of  mercantilist  policy.  But  it 
undoubtedly  owed  its  popular  support  to  the  prevalent  assump- 
tion that  an  inflow  of  specie  into  a  country  is  the  paramount 
requirement  for  national  affluence. 


S8  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Examples  of  mercantilist  doctrine  at  the  present  day  are 
legion;  for  the  financial  and  business  press  of  the  country  is 
continually  calling  attention  in  times  of  large  exports  to  the 
enormous  gains  that  are  accruing  to  the  nation.  To  give 
but  a  single  quotation,  a  well-known  financial  writer  stated  in 
1916  that  "  the  great  balance  of  trade  in  our  favor,  amounting  to 
practically  one  billion  dollars,  is  very  gratifying  to  the  American 
people  and  to  the  American  government."* 

The  doctrine  that  we  should  "  patronize  home  industry  "  affords 
another  illustration  of  the  prevalent  confusion.  Closely  akin  to 
the  supposed  advantages  of  a  favorable  balance  of  trade  with 
other  nations  is  the  contention  that  it  is  the  duty  of  the  people 
of  all  communities  to  patronize  home  industry.  The  following 
quotations  indicate  the  assumed  advantages  of  trading  only 
with  local  dealers: 

A  dollar  spent  in  Auburn  gives  you  another  chance  at  it;  but,  if 
it  is  spent  out  of  town,  it's  "Good-bye,  Mary." 

Down  with  the  parcels  post.  No  more  diabolical  device  was 
ever  perfected  by  the  big  cities  for  stripping  the  small  towns  and 
country  districts  of  all  their  surplus  cash.  Yet  the  rich  mail-order 
houses  wax  fat  with  the  dollars  that  are  the  property  of  local  mer- 
chants. 

The  individual  can  get  rich  only  by  selling  more  than  he  buys. 
Likewise  a  community  can  prosper  only  by  selling  to  other  com- 
munities more  than  it  buys  from  them. 

The  annual  influx  of  students  and  other  outsiders  into  our  fruit 
belt  to  engage  in  fruit-picking  and  packing  is  an  abuse  that  should 
be  stopped  at  once.  These  people  consume  very  little,  saving  their 
money  to  take  back  to  Ann  Arbor,  Madison,  Champaign,  and  other 
places  from  which  they  come.  Thus,  while  making  large  sums  off 
us,  they  give  little  or  nothing  in  support  of  our  industries. 

The  county  commissioners  should  be  promptly  impeached  and 
removed  from  office  for  their  action  last  Monday.  We  understand 
that  the  contract  for  the  building  of  the  new  courthouse  was  let  to 

» The  fallacy  in  this  reasoning  is  revealed  in  chaps,  viii  and  xv  dealing 
respectively  with  the  mechanism  of  foreign  exchange  and  the  problems  of 
post-war  readjustments  occasioned  by  the  unprecedented  redistribution  of 
the  gold  supply  of  the  world  that  occurred  during  the  Great  War. 


PECUNIARY  SYSTEM  AND  ECONOMIC  STANDARDS      $9 

the  Knoxville  firm  only  because  their  bid  was  $i,8oo  under  that  of 
our  fellow-citizen,  James  R.  Robertson.  Robertson,  as  we  are  all 
aware,  is  an  expert  at  this  line  of  work,  and  was  well  equipped  to 
do  a  handsome  job.  The  only  excuse  which  the  commissioners  give 
is  the  $i,8oo.  But  against  this  must  be  set  down  the  $32,000  which 
will  be  paid  to  the  Knoxville  gang.  Think  of  it!  Sending  $32,000 
out  of  town  to  save  a  paltry  $1 ,800. 

The  system  of  pecuniary  evaluations  often  serves  to  obscure 
fundamental  economic  conditions.  An  excellent  example  of  the 
way  in  which  the  system  of  evaluating  wealth  in  terms  of  money 
tends  to  obscure  actual  economic  conditions  and  lead  to  errone- 
ous conclusions  is  found  in  the  events  of  the  past  six  years.  The 
great  rise  in  prices  that  occurred  in  the  United  States  during 
the  years  from  1914  to  1919,  accompanied  as  it  was  by  a  great 
increase  in  the  quantity  of  circulating  medium,  has  resulted  in 
much  confusion  of  thought  on  such  matters  as  national- pros- 
perity, the  distribution  of  this  world's  goods,  profiteering,  etc. 
We  have  finally  come  to  learn  that  the  increase  in  monetary 
wages  does  not  benefit  laborers  so  long  as  the  prices  of  com- 
modities which  they  must  buy  are  proportionally,  or  more 
than  proportionally,  higher;  but  it  took  some  time  for  people 
to  appreciate  fully  that  an  increased  monetary  wage  does  not 
necessarily  carry  with  it  an  increased  standard  of  living. 

Most  people  in  the  United  States  do  not  even  yet  understand 
that  the  figures  which  are  everywhere  quoted  showing  the 
great  increase  in  national  wealth  are  largely  illusory.  This 
increased  wealth  is  measured  in  terms  of  a  depreciated  pecuniary 
unit.  With  prices  twice  as  high  in  1920  as  they  were  in  19 14, 
the  number  of  dollars'  worth  of  wealth  in  the  country  in  1920 
may  be  double  that  in  19 14  without  there  being  any  increase 
whatever  in  the  wealth  of  the  nation,  as  measured  by  actual 
goods  and  services. 

The  increase  in  bank  deposits  is  repeatedly  pointed  to  as  an 
evidence  of  the  great  increase  in  the  nation's  wealth,  but  the 
truth  is  that  the  doubled  price  level  now  requires  business  men 
to  use  twice  the  volume  of  funds  in  order  to  conduct  the  same 
volume  of  productive  and  trading  operations  as  in  19 14.  The 
increased  deposits  are  thus  merely  a  reflection  of  a  changed 


6o  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

price  level.  Incidentally,  the  United  States,  which  has  suffered 
less  from  the  ravages  of  war  than  any  of  the  other  great  nations, 
has  not  shown  as  rapid  an  increase  of  deposits  as  have  the 
European  countries;  for  the  greater  the  rise  in  the  level  of 
prices,  the  greater  is  the  increase  in  the  volume  of  deposits. 

It  is  also  frequently  observed  that  the  war  has  given  rise  to 
a  great  increase  in  the  number  of  millionaires — from  seven 
thousand  to  thirty  thousand — and  it  is  widely  believed  that  this 
was  a  direct  result  of  profiteering.  Some  of  it,  no  doubt,  is 
attributable  to  large  profits  derived  from  the  production  of  war 
materials.  But,  speaking  generally,  every  man  whose  prop- 
erty was  valued  before  the  war  at  five  hundred  thousand 
dollars  would,  merely  by  virtue  of  the  inflation  of  prices  that 
has  occurred,  now  find  such  property  worth  a  million  dollars. 
His  rjeal  wealth,  however,  would  obviously  not  have  increased 
at  all. 

The  increase  in  net  earnings  of  corporations  and  in  dividends 
paid  to  stockholders  is  everywhere  pointed  to  as  evidence  of 
an  increase  of  wealth.  FaiUng  to  realize  that  these  increased 
net  earnings,  in  many  instances,  at  least,  no  more  than  com- 
pensate for  the  changes  in  the  price  level,  the  capitalist  class 
deludes  itself  with  the  belief  that  earnings  are  unprecedentedly 
large,  while  labor  insists  that  profiteering  is  everywhere  rampant, 
and  that  there  is  no  valid  reason  why  wages  should  not  be 
greatly  increased  at  the  expense  of  profits.  In  other  words,  the 
monetary  basis  of  reckoning  serves  under  these  conditions  to 
conceal  the  real  economic  position  of  the  various  classes;  and 
the  consequent  misunderstanding  is  one  of  the  chief  factors  in 
the  social  unrest  of  the  time. 

III.    THE  QUANTITY  OF  MONEY  REQUIRED 

BY  A  NATION 
We  have  no  doubt  been  giving  the  impression  in  this  chapter 
that  the  quantity  of  money  within  a  country  is  a  matter  of 
entire  indifference,  that  actual  goods  and  services  are  alone 
important.  It  is  not  strictly  true,  however,  that  the  amount 
of  currency  supply  is  of  no  consequence  in  a  society  that  is 


PECUNIARY  SYSTEM  AND  ECONOMIC  STANDARDS      6l 

organized  on  a  pecuniary  basis.  Indeed,  under  the  conditions 
that  actually  obtain  an  increasing  volume  of  currency  may 
sometimes  be  a  matter  of  real  importance,  while  at  other  times 
a  decreasing  supply  would  prove  advantageous.  How  much 
money,  then,  does  a  nation  need  ?  To  answer  this  question  with 
entire  satisfaction  is  impossible  at  this  juncture,  but  the  general 
principles  involved  may  at  least  be  suggested. 

It  is  necessary  in  this  connection  to  distinguish  between 
standard  money  and  subsidiary  forms  of  currency,  which 
serve  as  media  of  exchange.  As  for  the  quantity  of  gold  that  is 
necessary,  it  may  be  pointed  out,  first,  that  a  considerable 
volume  of  gold  is  required  for  the  settlement  of  international 
trade  balances,  which — between  gold  standard  countries — have 
to  be  met  in  gold.  The  supply  of  gold  should  be  large  enough 
to  permit  the  payment  of  foreign  obligations  without  causing 
a  serious  impairment  of  the  gold  reserves  that  support  a  nation's 
monetary  system.  Under  normal  circumstances  there  is  little 
difficulty  in  this  connection;  but  there  are  times  when  an 
outflow  of  gold  reserves  may  imperil  the  entire  financial  and 
business  structure.' 

Second,  since  the  standard  money,  gold,  is  the  regulator  of 
all  other  forms  of  currency,  including  not  only  subsidiary  coins 
and  the  ordinary  forms  of  paper  money,  but  also  deposit  or 
"check"  currency  created  by  the  commercial  banks,^  the  stock 
must  be  large  enough  to  insure  the  maintenance  of  all  these 
other  forms  of  currency  at  a  parity  with  gold.  The  proper 
ratio  of  gold  to  the  total  quantity  of  currency  redeemable  in 
gold  varies  widely,  depending  upon  the  fundamental  conditions 
of  business,  upon  the  length  of  time  over  which  there  has  been 
no  depreciation  of  these  forms  of  currency,  and  upon  the 
general  attitude  of  the  people  with  reference  to  the  maintenance 
of  a  sound  monetary  system. 

The  amount  of  subsidiary  currency  that  is  required  also 
varies.  It  should  be  adequate  to  meet  the  needs  of  retail 
trade  and  other  exchange  operations  requiring  the  use  of  small 

'  See  pp.  117  and  270-73. 

'  See  chapters  on  commercial  banking,  below. 


62  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

currency  denominations,  as  denoted  by  the  demand  for  "change" 
at  the  banks;  and  tiie  amount  required  for  these  purposes 
depends  upon  both  the  price  level  and  the  volume  of  business 
that  is  being  transacted.  The  sharp  rise  in  prices  during  the 
war,  for  instance,  enormously  increased  the  demand  for  sub- 
sidiary currency  of  all  denominations.  Seasons  of  great  busi- 
ness activity  have  a  similar  effect. 

Writers  customarily  argue  that  the  total  quantity  of  media 
of  exchange,  including  standard  money,  subsidiary  coins,  paper 
currency,  and  checks,  should  be  gradually  expanded  in  pro- 
portion to  the  expansion  in  the  volume  of  business.  It  is 
believed  that  under  these  circumstances  the  price  level  would 
remain  unchanged,  thus  avoiding  the  serious  maladjustments 
incident  to  fluctuating  prices.  This  is,  however,  very  difficult, 
if  not  impossible  of  attainment  in  practice;  for  the  reason  that 
the  supply  of  gold  money  is  dependent  upon  the  productivity 
of  the  mines  and  the  varying  demands  for  gold  in  the  arts; 
while  the  amount  of  money  required  for  exchange  purposes  is 
dependent  upon  the  rapidity  of  turnover,  or  the  "velocity 
of  circulation"  of  given  units  of  money,  upon  the  effectiveness 
with  which  the  whole  monetary  and  banking  system  is  organ- 
ized, as  also  upon  the  conditions  of  business  activity.  During 
the  dull  seasons  of  the  year  money  may  be  relatively  "easy," 
while  in  the  months  of  great  activity  the  scarcity  of  available 
funds  may  prove  a  serious  handicap  to  business.  What  is 
needed  is  an  elastic  currency — one  that  will  expand  to  meet 
unusual  requirements.'  Similarly,  in  years  of  great  business 
activity  there  is  a  very  heavy  demand  for  funds.  Business 
men,  whether  engaged  in  the  production  or  in  the  marketing 
of  goods,  require  "liquid"  capital  with  which  to  finance  their 
operations.  If  money  is  "  tight "  there  is  a  limit  to  the  expansion 
of  business  that  can  occur.  A  consideration  of  the  expansibility 
required  in  our  monetary  system  must,  however,  be  postponed; 
for  it  involves  an  analysis  of  the  mechanism  of  commercial 
banking.' 

'  For  a  discussion  of  the  problem  of  elastic  currency  see  pp.  497-502. 
*See  chapters  on  commercial  banking,  below. 


PECUNIARY  SYSTEM  AND  ECONOMIC  STANDARDS      6$ 

QUESTIONS  FOR  DISCUSSION 

1.  What  do  you  understand  is  meant  by  the  term  "pecuniary 
system"? 

2.  Has  your  experience  been  that  most  of  the  affairs  of  life  are 
measured  either  directly  or  indirectly  in  terms  of  money? 

3.  Is  it  not  true  that  "money  talks"?  Does  it  speak  as  loudly 
now  as  it  did  before  the  war  ? 

4.  "  It  is  not  so  much  a  question  of  how  you  got  it,  as  have  you  got  it." 
What  does  "it"  refer  to?    Do  you  agree  with  the  sentiment? 

5.  "Not  what  a  man  has,  but  what  he  is."  Which  is  more  impor- 
tant (a)  practically  speaking  ?  {b)  ideally  speaking  ? 

6.  In  view  of  the  domination  of  the  pecuniary  system  over  the 
activities  and  thoughts  of  men,  does  it  seem  to  you  probable  that 
the  free  play  of  private  initiative  in  quest  of  pecuniary  gain 
tends  to  promote  the  general  welfare:  (c)  always  (b)  on  the 
whole  ? 

7.  "From  the  individual  point  of  view,  an  increased  quantity  of 
money  is  the  equivalent  of  an  increased  quantity  of  wealth. 
From  the  social  point  of  view  this  is  not  necessarily  the  case." 
Why  or  why  not  ? 

8.  If  the  pioneer  settlers  of  America  had  possessed  plenty  of  capital 
and  wealth,  do  you  think  they  would  have  been  desirous  of 
having  more  money?  With  greater  wealth,  would  more  or  less 
money  have  been  required,  in  fact  ? 

9.  What  did  the  pioneers  wish  to  do  with  additional  quantities  of 
money?  Is  it  possible  that  there  was  a  genuine  scarcity  of 
funds  for  business  purposes  ? 

10.  Do  you  find  any  evidences  of  mercantilist  doctrine  in  present-day 
discussions  on  foreign  trade  ? 

11.  Precisely  why  is  it  that  an  inflow  of  gold  into  a  country  is  con- 
sidered advantageous  ? 

12.  Are  there  ever  any  circumstances  under  which  a  large  and  con- 
tinuous flow  of  specie  into  a  coimtry  is  advantageous  ?  disadvan- 
tageous ? 

13.  What  nations  at  the  present  time  might  be  benefited  by  an  inflow 
of  specie  ?    (See  chapter  xv.) 

14.  Do  you  agree  with  any  of  the  arguments  given  in  the  text  for 
patronizing  home  industry  ? 

15.  How  would  you  measure  the  increase  in  the  nation's  wealth 
between  1914  and  1920  ? 


64  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

z6.  In  a  period  of  rising  prices,  why  do  bank  deposits  always  rapidly 
increase  ?    Does  this  necessarily  denote  great  prosperity  ? 

17.  Does  not  the  great  increase  in  the  number  of  millionaires  since 
1915  prove  that  there  has  been  unconscionable  profiteering? 

18.  Does  the  fact  that  wages  have  increased  from,  say,  nine  hundred 
to  eighteen  hundred  dollars  a  year  since  19x5  prove  that  there  has 
been  unconscionable  "wageering"  ? 

19.  A  retail  merchant  in  1914  receives  a  net  income  from  his  business 
of  $2,000.  In  1918,  with  prices  100  per  cent  higher,  he  receives 
$3,000  net  income.  Is  he  profiteering?  How  do  you  define 
profiteering  ? 

20.  Can  you  judge  whether  a  retailer  is  profiteering  by  ascertaining 
the  profit  margin  on  individual  articles  ?  How  can  you  teU  what 
is  a  legitimate  margin  of  profit  on  any  particular  commodity? 
Is  the  retailer's  business  one  of  joint  costs  ?    What  of  it  ? 

21.  If  the  net  earnings  of  a  corporation  doubled  in  amount  between 
1914  and  1918  would  you  say  that  the  corporation  was  profiteer- 
ing? 

22.  It  has  been  officially  stated  that  the  ptupose  of  the  government 
investigations  and  of  the  "fair  price  committees"  that  have  been 
established  is  to  reduce  the  cost  of  living.  Therefore,  if  it  is 
found  that  in  any  cases  prices  are  too  low,  they  shovdd  not  be 
raised.    Does  this  constitute  the  estabUshment  of  "fair"  prices  ? 

REFERENCES  FOR  FURTHER  READING 

Cooley,  Charles  H.:  Social  Process,  chaps,  xxvi-xxviii. 

Davenport,  H.  J.:   The  Economics  of  Enterprise,  pp.  21-23. 

Hamilton,  Walton  H.:  "The  Price  System  and  Social  Policy," 
Journal  of  Political  Economy,  January,  1918. 

Moulton,  Harold  G.;  Principles  of  Money  and  Banking,  Part  I, 
Selections  Nos.  9-25. 


CHAPTER  VI 

THE  REGULATION  OF  METALLIC 
CURRENCY 

In  order  that  money  may  perform  effectively  its  various 
functions  it  has  been  necessary  to  develop  a  system  of  regu- 
lation that  would  give  precision  to  business  transactions  in- 
volving the  use  of  money.  In  this  chapter  we  are  to  consider 
the  various  problems  that  have  arisen  in  connection  with  the 
regulation  of  the  different  forms  of  metallic  currency. 

I.    THE  NECESSITY  OF  GOVERNMENT  COINAGE 

The  j&rst  problem  is  that  of  coinage.  If  the  pieces  of  metal 
which  serve  as  money  were  not  of  uniform  certified  weight, 
it  is  evident  that  traders  would  be  put  to  no  end  of  iriconvenience 
in  weighing  the  currency  tendered  in  the  settlement  of  obliga- 
tions. Because  of  the  high  value  of  gold  and  other  precious 
metals  a  very  sHght  variation  in  weight  would  involve  con- 
siderable loss. 

Quite  as  important  as  the  question  of  uniform  weight  is 
that  of  uniform  fineness.  Bullion  containing  gold  and  silver 
varies  widely  in  the  amount  of  impurities  contained  therein; 
and  it  is  accordingly  necessary  that  it  be  assayed  before 
coining.  It  is  also  easy  to  melt  up  gold  and  silver  coins  and 
debase  them  by  adding  copper  or  other  metal.  In  order  to 
permit  exchanges  to  be  made  with  certainty,  it  is,  therefore, 
imperative  that  the  fineness  as  well  as  the  weight  of  coins  be 
attested. 

The  objects  to  be  attained  by  a  good  system  of  coinage  are 
stated  by  Jevons  as  foUows:    (i)  to  prevent  coimterf citing; 

(2)  to  prevent  the  fraudulent  removal  of  metal  trom  the  coin; 

(3)  to  reduce  the  loss  by  legitimate  wear  and  tear;  (4)  to  make 

6s 


66  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  coin  an  artistic  and  historical  monument  of  the  state  issuing 
it  and  the  people  using  it. 

Coinage  is  now  everywhere  a  government  function  though 
it  appears  that  in  earher  times  there  were  numerous  private 
mints.  The  reason  for  making  the  coinage  of  money  a  govern- 
ment prerogative  is  readily  apparent.  Even  if  private  coiners 
could  be  relied  upon  always  to  put  the  same  imount  of  pure 
metal  into  a  coin,  the  various  private  coiners  might  neverthe- 
less issue  dollars  of  different  weights  and  fineness.  One  would 
therefore  always  need  to  know  whose  dollar  it  was  that  he  was 
to  receive  in  payment  of  obligations;  and  we  should  have  as 
many  different  prices  as  there  were  different  pecuniary  units. 
A  monopoly  of  coinage  is  obviously  necessary  to  insure  uni- 
formity of  the  currency.  A  private  monopoly  in  the  coining 
of  money  is  clearly  undesirable, 

A  defective  coinage  permits  the  operation  of  Gresham's  law. 
Whenever  legal  tender  coins  of  the  same  face  value,  but  of 
different  weights  or  degrees  of  fineness,  are  in  concurrent  circula- 
tion the  light-weight  or  base  coins  tend  to  drive  the  full-weight 
pure  coins  out  of  circulation.  This  fundamental  monetary 
law  derives  its  name  from  Sir  Thomas  Gresham,  a  royal  agent 
of  Queen  EUzabeth,  who  first  expressed  in  precise  terms  a 
phenomenon  that  had  long  been  observed. 

The  reason  why  the  light-weight  or  base  coins  will  drive 
the  full-weight  and  pure  coins  out  of  circulation — wholly  or  in 
part — is  not  difficult  to  see.  In  making  foreign  payments 
money  is  accepted  only  by  weight;  hence  the  full- weight  and 
pure  coins  are  sent  out  of  the  country  in  payment  of  foreign 
balances,  while  the  base  or  light-weight  coins  are  kept  in  the 
domestic  circulation.  Full-weight  and  pure  coins  may  also  be 
melted  down  and  used  as  bullion.  While  the  general  public 
does  not  discriminate  between  coins  unless  there  is  a  con- 
siderable variation  in  value,  money  changers,  buUion  dealers, 
and  bankers  are  quick  to  derive  a  profit  from  such  varia- 
tions. History  is  replete  with  instances  where  Ught-weight 
and  base  coins  have  driven  the  "good  coins"  entirely  out  of 
circulation, 


REGULATION  OF  METALLIC  CURRENCY  67 

n.    ECONOMIC  AND  SOCIAL  EFFECTS  OF  A 
BAD  COINAGE  SYSTEM 

Marked  differences  in  the  weight  and  fineness  of  coins,  such 
as  frequently  occurred  before  the  coinage  process  was  perfected, 
usually  lead  to  disastrous  social  consequences.  For  instance, 
Macaulay  tells  us  that:^ 

The  old,  crude,  hammered  coins  of  Great  Britain  were  of  varying 
weight,  slightly  irregular  shape,  and  with  unmilled  edges.    As  a 

result  they  were  easily  cUpped  and  mutilated In  the  autumn 

of  1695  it  could  hardly  be  said  that  the  country  possessed,  for  prac- 
tical purposes,  any  measure  of  value.  It  was  a  mere  chance  whether 
what  was  called  a  shilling  was  really  tenpence,  sixpence,  or  a  groat. 
The  results  of  some  experiments  that  were  tried  at  that  time  deserve 
to  be  mentioned.  The  officers  of  the  exchequer  weighed  £57,200 
of  hammered  money  which  had  recently  been  paid  in.  The  weight 
ought  to  have  been  220,000  ounces.  It  proved  to  be  under  114,000 
ounces.  Three  eminent  London  goldsmiths  were  invited  to  send 
£100  each  in  current  silver  to  be  tried  by  the  balance.  The  £300 
ought  to  have  weighed  almost  1,200  ounces.  The  actual  weight 
proved  to  be  624  ounces.  The  same  test  was  applied  in  various 
parts  of  the  kingdom  with  practically  everywhere  similar  results. 

Interestingly  enough,  although  the  penalties  against  clipping 
and  mutilating  the  currency  were  most  severe,  it  was  almost 
impossible  to  check  the  practice.     Says  Macaulay: 

The  severity  of  the  punishment  (clipping  carried  the  penalty  of 
death)  gave  encouragement  to  the  crime.  For  the  practice  of  cUpping 
did  not  excite  in  the  commoji  mind  a  detestation  resembling  that  with 
which  men  regard  murder,  arson,  robbery,  nay,  even  theft.  The 
injury  done  by  the  whole  body  of  chppers  to  society  as  a  whole  was 
indeed  immense;  but  each  particular  act  of  clipping  was  a  trifle. 
To  pass  a  half-crown  after  paring  a  pennyworth  of  silver  from  it 
seemed  a  minute  and  almost  imperceptible  fault.  Even  while  the 
nation  was  crying  out  most  loudly  under  the  distress  which  the  state 
of  the  currency  had  produced,  every  individual  who  was  capitally 
punished  for  contributing  to  bring  the  currency  into  that  state  had 
the  general  sympathy  on  his  side.     Constables  were  unwUhng  to 

'  FroQi  ffistorv  of  Eneland  (1848),  chap,  xxi. 


68  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

arrest  the  offenders.  Justices  were  unwilling  to  commit.  Witnesses 
were  unwilling  to  tell  the  whole  truth.  Juries  were  unwilling  to 
pronounce  the  word  guilty.  There  was  a  general  conspiracy  to 
prevent  the  law  from  taking  its  course  ....  the  offenders  who  were 
convicted  looked  on  themselves  as  murdered  men,  and  were  firm  in 
the  belief  that  their  sin,  if  sin  it  were,  was  as  venial  as  that  of  a 
schoolboy  who  goes  nutting  in  the  wood  of  a  neighbor. 

These  examples  clearly  reveal  the  paramount  necessity 
of  a  uniform  currency.     Macaulay  concludes  that: 

It  may  well  be  doubted  whether  all  the  misery  which  had  been 
inflicted  on  the  English  nation  in  a  quarter  of  a  century  by  bad  kings, 
bad  ministers,  bad  Parliaments,  and  bad  judges  was  equal  to  the 
misery  cavised  by  bad  crowns  and  bad  shillings.  Those  events  which 
furnish  the  best  themes  for  pathetic  or  indignant  eloquence  are  not 
always  those  which  most  affect  the  happiness  of  the  great  body  of  the 
people.  The  misgovernment  of  Charles  and  James,  gross  as  it  had 
been,  had  not  prevented  the  common  business  of  life  from  going 
steadily  and  prosperously  on.  While  the  honor  and  independence 
of  the  state  were  sold  to  a  foreign  power,  while  chartered  rights  were 
invaded,  while  fundamental  laws  were  violated,  hundreds  of  thou- 
sands of  quiet,  honest,  and  industrious  families  labored  and  traded, 
ate  their  meals,  and  lay  down  to  rest,  in  comfort  and  security.  But 
when  the  great  instrmnent  of  exchange  became  thoroughly  deranged, 
all  trade,  all  industry,  were  smitten  as  with  a  palsy.  The  evil  was 
felt  daily  and  hourly  in  almost  every  place  and  by  almost  every  class, 
in  the  dairy  and  on  the  threshing-floor,  by  the  anvil  and  by  the  loom, 
on  the  billows  of  the  ociean  and  in  the  depths  of  the  mine.  Nothing 
could  be  purchased  without  a  dispute.  Over  every  counter  there 
....  was  wrangling  from  morning  to  night.  The  workman  and  his 
employer  had  a  quarrel  as  regularly  as  the  Saturday  came  around. 
On  a  fair  day  or  a  market  day  the  clamors,  the  reproaches,  the 
curses,  were  incessant;  and  it  was  well  if  no  booth  was  overturned 
and  no  head  broken.  No  merchant  covdd  contract  to  deUver  goods 
without  making  some  stipulation  about  the  quality  of  the  coin  in 
which  he  was  to  be  paid.  Even  men  of  business  were  often  bewildered 
by  the  confusion  into  which  all  pecuniary  transactions  were  thrown. 
The  simple  and  the  careless  were  pillaged  without  mercy  by  extor- 
tioners whose  demands  grew  even  more  rapidly  than  the  money 
shrank.    The  price  of  the  necessaries  of  life,  of  shoes,  of  ale,  of 


REGULATION  OF  METALLIC  CURRENCY  69 

oatmeal,  rose  fast.  The  laborer  found  that  the  bit  of  metal  which, 
when  he  received  it,  was  called  a  shilling,  would  hardly,  when  he 
wanted  to  purchase  a  pot  of  beer  or  a  loaf  of  bread,  go  as  far  as  a 
sixpence. 

III.    COINAGE  RULES  AND  REGULATIONS  OF 
THE  UNITED  STATES 

The  following  rules  and  regulations^  govern  the  coinage 
process  at  the  present  time  in  the  United  States: 

a)  Receipt  of  bullion. — ^All  bvdhon  deposited  or  purchased  at 
any  of  the  mints  or  assay  offices  of  the  United  States  shall  be  weighed 
in  the  presence  of  the  depositor  or  his  agent,  and  the  weight  shall  be 
verified  by  the  registrar  of  deposits.  If  the  bullion  deposited  is 
found  to  be  of  less  value  than  $100,  it  may  be  legally  refused.  If, 
upon  report  of  the  assayer,  it  is  found  to  be  unsuitable  for  the  opera- 
tions of  the  mint,  it  shall  be  refused. 

b)  Assaying. — ^As  soon  as  the  weight  of  a  deposit  has  been  ascer- 
tained and  recorded,  the  assayer  takes  at  least  two  samples  in  suffi- 
cient portion  for  assay  and  proceeds  to  test  the  quality  of  the  metal. 
The  assayer  shall  insert  in  the  report  the  fineness  of  the  gold  or  silver 
contained  in  the  deposit.  If  the  base  is  ascertained  to  be  copper 
suitable  for  standard  metal,  he  shall  so  state  in  his  report.  He 
shall  also  insert  in  his  report  the  charges  to  which  the  deposit  is 
subject. 

c)  Mint  charges. — Section  3524,  Revised  Statutes  of  the  United 
States,  provides  that  the  charges  for  the  various  operations  on  bullion 
deposited  and  for  the  preparation  of  bars  shall  be  fixed  from  time  to 
time  by  the  Director  of  the  Mint,  with  the  concurrence  of  the  Secre- 
tary of  the  Treasury,  so  as  to  equal,  but  not  exceed,  in  their  judg- 
ment, the  actual  average  cost  to  each  mint  and  assay  office  of  the 
material,  labor,  wastage,  and  use  of  machinery  employed.  The 
following  are  the  principal  mint  charges: 

I.  Melting  charge. — On  deposit  of  bulUon  a  charge  of  $1  shall  be 
imposed  for  each  i  ,000  ounces  of  buUion  or  fraction  thereof  as  shown 
by  weight  after  melting,  except  in  the  case  of  uncurrent  United  States 
coin  and  mint-fine  bars  for  which  no  charge  is  made. 

*  Adapted  from  General  Instructions  and  Regulations  in  Relation  to 
the  Transaction  0}  Business  at  the  Mints  and  Assay  Offices  of  the  United 
States. 


76  THE  FINANCIAL  ORGANIZATtON  OF  SOCIETY 

2.  Parting  and  refining  bullion. — ^The  charges  for  parting  and 
refining  bullion  vary  with  the  amount  of  impurities  and  base  metal. 
Bullion  containing  800  thousandths  or  more  of  base  metal  is  not 
accepted.  At  the  other  extreme  no  charge  is  made  for  bullion  contain- 
ing 992  thousandths  of  gold  and  upward.  The  charges  on  other  bullion 
vary  from  one-half  cent  per  ounce  to  four  cents  per  ounce,  depending 
upon  the  amount  of  base  metals  and  copper  alloy  contained.  For 
instance,  where  bullion  contains  from  950  to  991^  thousandths  inclu- 
sive of  gold  and  not  more  than  30  thousandths  base,  the  charge  is 
two  cents  per  ounce.  The  depositor  is  given  credit  for  the  copper 
contained  in  the  bullion.  There  is  no  charge  for  parting  and  refining 
foreign  coins  unless  they  are  below  standard  fineness. 

3.  Toughening  charge. — Bullion  containing  one  or  more  of  the 
following  substances,  viz.,  iron,  lead,  antimony,  bismuth,  tin,  arsenic, 
zinc,  or  sulphur,  in  amounts  sufi&cient  to  make  it  impossible  to  obtain 
a  satisfactory  assay,  shall,  at  the  discretion  of  the  superintendent, 
be  subject  to  an  additional  charge  equal  to  the  cost  to  the  government 
for  remelting  and  treatment  by  the  deposit  melter. 

4.  Copper  alloy. — ^Two  cents  per  ounce  for  copper  required,  to 
be  determined  by  taking  one-tenth  of  the  standard  weight  of  gold, 
except  where  the  base  in  the  deposit  is  all  good  copper  and  the  fine- 
ness above  standard,  when  the  method  of  determining  the  number 
of  ounces  of  copp>er  required  shall  be  by  taking  the  difference  between 
the  standard  weight  and  the  gross  weight  of  the  deposit. 

5.  Assays  of  bullion  and  plated  ware. — Samples  of  gold  and  silver 
bullion  will  be  assayed  at  the  mints  and  assay  offices  at  a  charge  of 
$2  per  sample.  In  case  of  plate,  or  what  is  known  as  rolled  or  filled 
plate,  the  charge  shall  be  $4  for  each  assay;  or  the  assay  may  be 
refused,  at  the  option  of  the  assayer. 

d)  Advances  or  partial  payments  on  deposits. — ^In  case  of  deposits, 
the  fineness  of  which  may  be  readily  determined  approximately  by 
inspection,  payments  may,  at  the  discretion  of  the  superintendents  of 
the  coinage  mints  and  the  assay  office  at  New  York,  be  made  within 
10  per  cent  of  their  value,  or  within  2  per  cent  when  already  closely 
determined  by  assay  and  awaiting  remelting  or  reassay  for  exact 
determination:  provided,  no  partial  payment  shall  be  made  on  a 
deposit  containing  less  than  $5,000  in  gold,  or  5,000  ounces  of  silver. 

e)  Deposits  of  United  Slates  coin. — United  States  gold  coin  of 
legal  weight  shall  not  be  received  from  depositors  except  in  sums  of 
not  less  than  $5,000  in  exchange  for  gold  bars. 


REGULATION  OF  METALLIC  CURRENCY  Jt 

Mutilated  or  otherwise  uncurrent  United  States  gold  coins,  of  any 
denomination,  will  be  received  at  any  of  the  mints  or  assay  offices 
of  the  United  States,  and  the  value  of  the  fine  gold  contained  will  be 
paid  to  the  depositor  at  the  rate  of  $20.67  per  ounce  fine,  or  $18.60 
per  ounce  standard  (0.900  fine). 

/)  Mode  of  payments. — Payments  for  deposits  of  gold  bullion 
at  the  coinage  mints  and  at  the  assay  oflSce  in  New  York  will  be  made 
in  fine  bars,  coin,  or  by  check,  as  may  be  desired  by  the  depositor. 
At  the  minor  assay  offices  payments  are  made  by  check  on  an  Assist- 
ant Treasurer  of  the  United  States,  or  government  depository  bank 
nearest  at  hand. 

g)  Manufacture  of  bars. — Unparted,  fine,  and  standard  bars  may 
be  manufactured  at  the  coinage  mints  and  the  assay  office  at  New 
York,  and  unparted  bars  at  aU  of  the  institutions.  Fine  bars  may 
be  approved  when  they  have  a  fineness  of  0.992  and  upward,  and  no 
bar  of  gold  or  silver  of  less  weight  than  5  ounces  shall  be  issued  at 
any  of  the  mints  or  assay  offices  of  the  United  States. 

h)  The  "tolerance  of  the  mint"  and  "trial  of  the  pyx." — ^The 
weight  of  a  new  gold  eagle,  or  double  eagle,  must  not  vary  more 
than  half  a  grain  from  the  standard  weight  fixed  in  the  law.  That 
of  the  smaller  gold  coins  must  not  vary  more  than  a  quarter  of 
a  grain.  This  allowable  variation  is  called  the  "tolerance  of  the 
mint." 

The  testing  of  this  weight  is  determined  by  a  "trial  of  the  pyx." 
Five  pieces  out  of  every  thousand  coined  are  taken  out  by  the  superin- 
tendent upon  receipt  from  the  coiner  and  tried  separately  by  him. 
If  successful,  these  pieces  are  sealed  and  deposited  in  a  pyx  which  is 
kept  under  the  joint  care  of  the  superintendent  and  the  assayer 
and  secured  so  that  neither  can  have  access  to  its  contents  without 
the  presence  of  the  other. 

If  the  original  trial  by  the  superintendent  proves  imsatisfactory, 
all  the  coins  shall  be  weighed  separately,  and  such  as  are  not  of  legal 
weight  shaU  be  defaced  and  delivered  to  the  melter  and  refiner. 
Four  times  a  year  the  samples  from  the  minor  mints  are  sent  to  the 
mint  at  Philadelphia.  The  entire  quantity  of  samples  is  then  sub- 
jected to  an  annual  "  trial  of  the  pyx"  by  a  special  Assay  Commission, 
composed  of  the  judges  of  the  district  court  of  the  eastern  district 
of  Pennsylvania,  the  Comptroller  of  the  Currency,  the  Assayer  of 
the  assay  office  at  New  York,  and  such  other  persons  as  the  President 
may  from  time  to  time  designate.    If  an  error  is  found,  the  officers 


72  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

implicated  in  the  error  are  thenceforward  disqualified  from  holding 
their  respective  oflfices. 

The  penalty  imposed  upon  an  officer  of  the  mint  for  debasing, 
embezzling,  or  ia  any  way  altering  coins,  or  for  tami)ering  with  the 
scales  or  weights  used  at  the  mints,  shall  be  a  fine  of  not  more  than 
ten  thousand  dollars  and  imprisonment  for  not  more  than  ten  years. 

i)  The  standard  troy  pound. — For  the  purpose  of  securing  a  due 
conformity  in  weight  of  the  coins  of  the  United  States  to  the  provisions 
of  this  title,  the  brass  troy  pound  weight  procured  by  the  minister  of 
the  United  States  at  London,  in  the  year  eighteen  hundred  and 
twenty-seven,  for  the  use  of  the  mint,  and  now  in  the  custody  of  the 
mint  in  Philadelphia,  shall  be  the  standard  troy  pound  of  the  mint  of 
the  United  States,  conformably  to  which  the  coinage  thereof  shall 
be  regulated.  Duplicates  of  this  standard  troy  pound  shall  be  pro- 
cured for  the  other  mints  and  assay  offices.  Inspection  and  testing 
of  these  shall  be  made  annually  by  the  Assay  Commission  along  with 
the  testing  of  coins. 

j)  Abrasion. — ^Where  gold  is  used  extensively  as  a  circulating 
medium  there  is  a  considerable  loss  from  wear  and  tear,  or  abrasion. 
The  law  in  the  United  States  permits  an  abrasion  equal  to  one-half  of 
I  per  cent  in  twenty  years,  and  proportionally  for  each  year.  For 
instance,  an  eagle  at  the  end  of  twenty  years  would  be  current  if  it 
weighed  only  256.71  grains  instead  of  258  (or  258.50  when  allow- 
ance is  made  for  the  tolerance  of  the  mint).  The  annual  abrasion 
permissible  is  0.0645  grains.  Experiments  have  shown  that  this 
limit  of  abrasion  is  high  enough  to  avoid  frequent  recoinage  in  the 
United  States. 

In  case  a  gold  coin  is  uncurrent  on  account  of  abrasion  in  the 
United  States,  the  loss  falls  on  the  last  holder.  This  appears  like  an 
injustice,  since  the  loss  is  due  to  social  wear.  It  has  thus  far  been 
held,  however,  that  the  impossibility  of  determining  whether  the  light 
weight  is  due  to  abrasion  or  sweating  makes  it  necessary  to  charge  the 
loss  entirely  to  the  last  holder. 

k)  Counterfeiting. — "Whoever  shall  falsely  make,  forge,  or 
coimterfeit,  or  cause  or  procure  to  be  falsely  made,  forged,  or  counter- 
feited, or  shall  willingly  aid  or  assist  in  falsely  making,  forging,  or 
counterfeiting  any  coin  or  bars  in  resemblance  or  similitude  of  the 
gold  or  silver  coins  or  bars  which  have  been,  or  hereafter  may  be, 
coined  or  stamped  at  the  mints  and  assay  offices  of  the  United  States, 
or  in  resemblance  or  simiUtude  of  any  foreign  gold  or  silver  coin  which 


REGULATION  OF  METALLIC  CURRENCY  73 

by  law  is,  or  hereafter  may  be,  current  in  the  United  States,  or  are  in 
actual  use  and  circulation  as  money  within  the  United  States;  or 
whoever  shall  pass,  utter,  publish,  or  sell,  or  attempt  to  pass,  utter, 
publish,  or  sell,  or  bring  into  the  United  States  or  any  place  subject 
to  the  jurisdiction  thereof,  from  any  foreign  place,  knowing  the  same 
to  be  false,  forged,  or  counterfeit,  with  intent  to  defraud  any  body 
politic  or  corporate,  or  any  person  or  persons  whomsoever,  or  shall 
have  in  his  possession  any  such  false,  forged,  or  counterfeited  coin 
or  bars,  knowing  the  same  to  be  false,  forged,  or  counterfeited,  with 
intent  to  defraud  any  body  politic  or  corporate,  or  any  person  or  per- 
sons whomsoever,  shall  be  fined  not  more  than  five  thousand  dollars 
and  imprisoned  not  more  than  ten  years."  For  counterfeiting  minor 
coins  the  penalty  is  a  fine  of  not  more  than  one  thousand  dollars  and 
imprisonment  for  not  more  than  three  years.  For  debasing,  defacing, 
injuring,  etc.,  any  gold  or  silver  coins  with  intent  to  defraud,  the 
penalty  is  not  in  excess  of  a  fine  of  two  thousand  dollars  and  imprison- 
ment for  five  years. 

/)  Mints  and  assay  offices. — To  facilitate  the  conversion  of 
bullion  into  coin,  mints  have  been  established  in  the  following  cities: 
Philadelphia,  Denver,  and  San  Francisco.  Assay  offices,  where  bullion 
can  be  exchanged  for  currency,  are  located  at  New  York,  New  Orleans, 
Carson,  Boise,  Helena,  Deadwood,  Seattle,  and  Salt  Lake  City. 

IV.    GRESHAM'S  LAW  AND  BIMETALLISM 

We  have  seen  that  under  a  poor  coinage  system,  with 
counterfeiting,  clipping,  and  sweating  everyday  occurrences, 
the  operation  of  Gresham's  law  tended  to  make  it  impossible 
to  keep  the  better  coins  in  circulation!  It  remains  to  discuss 
Gresham's  law  under  other  conditions — in  connection  with  a 
bimetallic  standard. 

Bimetallism  appears  to  have  been  adopted  by  all  the  leading 
European  countries  at  the  beginning  of  the  modern  era,  without 
discussion — as  a  mere  matter  of  course.  Since  both  gold  and 
silver  were  adapted  to  exchange  purposes  and  since  it  was 
everywhere  assumed  that  a  large  volume  of  currency  was  an 
unmitigated  blessing,  both  metals  appear  to  have  been  by 
common  consent  adopted  as  the  standard  of  value.  It  was  not 
until  late  in  the  eighteenth  century  that  any  agitation  for  the 


74  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

elimination  of  bimetallism  developed,  and,  save  in  England,  it 
was  not  until  the  latter  half  of  the  nineteenth  century  that  the 
double  standard  was  abohshed. 

The  fundamental  weakness  of  the  bimetallic  system  lies  in  the 
fact  thai  it  permits  the  operation  ofGresham's  law.  With  a  bime- 
tallic standard  gold  and  silver^  together  constituted  the  pecuni- 
ary unit  of  value.  For  example,  under  the  bimetallic  system 
which  existed  in  the  United  States  for  so  many  years,  both  gold 
and  silver  were  standard.  With  a  coinage  ratio  of  i6  to  i,  25.8 
grains  of  gold,  nine-tenths  fine  were  defined  as  a  dollar;  and  16 
times  that  weight,  or  412.5  grains,  of  silver,  nine-tenths  fine, 
were  also  defined  as  a  dollar.  Under  bimetalUsm,  Gresham's 
law  must  be  stated  in  slightly  different  terms,  as  follows:  When 
two  metals  of  the  same  nominal  value,  but  of  different  bulUon 
value,  are  freely  coinable  at  the  mints  and  of  unrestricted 
legal  tender  power,  the  metal  that  is  overvalued  at  the  mint 
tends  to  drive  the  other  from  circulation.  The  difficulty  in 
this  connection  may  best  be  illustrated  by  reference  to  some 
actual  cases  from  our  own  bimetaUic  history. 

Our  first  coinage  law,  passed  in  1792,  fixed  the  coinage  ratio 
of  silver  to  gold  at  15  of  the  former  to  i  of  the  latter.  At  the 
time,  the  relative  value  of  gold  and  silver  bullion  in  the  commer- 
cial markets  was  about  15 .3  to  i.  That  is  to  say,  it  took  15.3 
ounces  of  silver  to  equal  one  ounce  of  gold  in  the  form  of  bulUon; 
but  in  the  form  of  coins  it  took  only  15  ounces  of  silver  to 
equal  an  ounce  of  gold.  Accordingly,  silver  had  a  greater  value 
at  the  mint  than  it  had  in  the  form  of  bullion.  Since  specie 
must  always  be  used  in  making  international  payments,  gold 
rather  than  silver  was  always  sent  whenever  a  foreign  obligation 
had  to  be  settled.  Gold  was  quite:  as  good  as  silver  for  this 
purpose;  but,  on  the  other  hand,  it  did  not  pay  to  take  gold 
to  the  United  States  mint  to  be  coined,  because  it  had  a  greater 
exchange  power  as  bullion  than  it  had  as  coin.  Similarly,  it  did 
not  pay  to  ship  silver  out  of  the  country  in  settlement  of  foreign 
obligations,  because  silver  brought  a  higher  return  as  compared 
with  gold  when  it  was  taken  to  the  mint  and  converted  into  coins. 

*  Other  commodities  might,  of  course,  have  been  used. 


REGULATION  OF  METALLIC  CURRENCY  75 

Accordingly,  gold  was  driven  out  of  circulation  and  silver  became 
.  the  actual  standard  of  value. 

In  1834  Congress  changed  the  coinage  ratio  from  15  to  i  to 
16  to  I.  At  the  time  the  market  ratio  of  silver  to  gold  was 
about  15.7  to  I.  With  the  new  ratio  it  required  16  ounces 
of  silver  to  equal  one  ounce  of  gold  in  the  form  of  coins,  but 
only  15 .7  ounces  of  silver  to  equal  an  ounce  of  gold  in  the  form 
of  bullion.  Thus  gold  became  relatively  overvalued  at  the  mint, 
and  accordingly  gold  was  sent  to  the  mint  for  coinage,  whence 
it  shortly  reappeared  in  the  channels  of  circulation.  Indeed, 
even  before  the  act  was  finally  passed,  a  shipment  of  gold 
was  en  route  from  England  to  the  United  States  to  take  advan- 
tage of  its  overvaluation  at  the  United  States  mint. 

These  two  illustrations  will  suffice  to  show  the  principle 
involved.  Given  full  legal  tender  power  and  unrestricted 
coinage  at  the  mmt  at  a  given  ratio,  one  metal  will  drive  the 
other  from  circulation,  wholly  or  in  part,  whenever  the  market 
ratio  varies  from  the  mint  ratio.  Many  more  examples  might  be 
cited  from  our  own  history ;  and  every  country  that  has  employed 
the  double  standard  has  witnessed  the  same  phenomenon. 

The  controversy  over  bimetallism  waited  upon  the  perfection  of 
coinage  technique.  The  reason  why  the  controversy  over 
bimetallism  made  so  belated  an  appearance  was  -that  until  the 
coinage  process  had  been  perfected,  the  cause  for  a  disappear- 
ance of  metal  from  circulation  appeared  to  He  in  the  disparity 
in  value  between  light-weight,  debased  coins,  and  full-weight, 
pure  coins.  The  problem  appeared  to  be  merely  one  of  coinage 
technique.  But  after  the  great  im'provement  in  the  coinage 
process,  it  was  observed  that  the  cheaper  of  two  standard  metals 
still  drove  out  the  dearer  one.  Thus  a  disordered  currency,  due 
to  poor  coinage,  counterfeiting,  clipping,  etc.,  had  long  obscured 
the  operation  of  Gresham's  law  in  connection  with  bimetallism. 
When  this  phase  of  the  problem  of  monetary  regulation  eventu- 
ally became  clear,  a  movement  for  the  abolition  of  the  double 
standard  gradually  gained  headway. 

It  required  many  generations  to  secure  the  adoption  of  a 
single  gold  standard  by  all  the  leading  commercial  nations.    The 


76  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

elimination  of  silver  as  a  standard  coin  was  opposed  by  silver 
miners  for  obvious  reasons.  It  was  also  opposed  by  many 
people  who  confused  money  with  wealth  and  accordingly  be- 
lieved that  a  reduction  in  the  quantity  of  the  circulating 
medium  would  mean  a  net  reduction  in  the  nation's  wealth. 
The  establishment  of  a  single  gold  standard  was  also  strenu- 
ously opposed  by  the  debtor  class,  who  desired  rising  prices  as 
a  means  of  lessening  the  burden  of  their  indebtedness.' 

England  was  the  first  country  to  abandon  bimetallism,  the 
single  gold  standard  having  been  adopted  in  the  year  1816. 
Portugal  was  next  in  order,  abolishing  the  free  coinage  of  silver 
in  1854.  Three  years  later,  the  states  composing  the  German 
ZoUverein  and  the  empire  of  Austria  entered  into  a  monetary 
treaty  and  adopted  the  single  silver  standard.  ~  Shortly  after 
the  establishment  of  the  German  Empire  in  1871,  Germany, 
however,  shifted  to  the  single  gold  standard. 

The  states  composing  the  Latin  Monetary  Union  (France, 
Belgium,  Switzerland,  and  Italy),  which  had  been  formed  in 
1865  in  an  endeavor  to  secure  a  uniform  international  double 
standard,  one  by  one  virtually'  went  over  to  the  single  gold 
standard  in  the  decade  of  the  seventies. 

In  1873  the  Scandinavian  Monetary  Union  was  formed  by 
Norway,  Sweden,  and  Denmark,  and  a  single  gold  standard 
was  adopted.  In  1874  silver  wjis  entirely  demonetized. 
Holland  limited  the  coinage  of  silver  in  1873  and  two  years 
later  adopted  a  single  gold  standard.  Spain  began  the  restric- 
tion of  silver  money  in  1876,  and  completed  the  process  in  1878. 
In  1876  Russia  suspended  the  coinage  of  silver  for  individuals, 
except  as  required  for  trade  with  China.  In  1899  Russia 
adopted  the  single  gold  standard.  Finland  adopted  the  single 
gold  standard  in  1877,  and  in  1878  Austria-Hungary  abolished 
the  free  coinage  of  silver.  In  1893,  after  a  protracted  contro- 
versy, the  mints  of  India  were  closed  to  the  free  coinage  of  silver. 
And  in  1898  Japan  definitely  adopted  the  single  gold  standard. 

'  Compare  chap,  iii,  pp.  30-35. 

'I  say  virlitally  because  silver  was  usually  retained  as  a  standard  coin; 
it  was  thus  a  "limping"  standard  that  was  adopted. 


REGULATION  OF  METALLIC  CURRENCY  77 

Practically  all  of  the  small  states  of  the  world  have  also 
in  recent  years  adopted  either  the  single  gold  standard,  or  the 
gold  exchange  standard,  a  variation  of  the  principle  of  a  single 
gold  standard. 

In  revising  her  coinage  system  in  1873  the  United  States 
omitted  the  standard  silver  dollars  from  the  list  of  coins  that 
might  be  struck  at  the  mints,  and  thus  became  a  single  gold 
standard  country.  This  law  was  modified,  however,  under  the 
influence  of  the  sUver  mining  interests  and  of  those  who  desired 
a  cheaper  currency,  and  the  coinage  of  silver  was  partially 
restored  by  the  Bland-Allison  Act  of  1878.  Another  law, 
known  as  the  Sherman  Silver  Purchase  Act  of  1890,  still  further 
increased  the  quantity  of  silver  that  might  be  coined,  although 
it  did  not  go  so  far  as  to  restore  the  bimetallic  system.  The 
question  of  the  restoration  of  bimetallism  was  the  great  issue  in 
the  presidential  campaign  of  1896.  The  Republican  party, 
standing  for  the  single  gold  standard  for  the  United  States 
until  such  time  as  the  leading  commercial  nations  of  the  world 
should  agree  to  adopt  "international"  bimetallism,  was  suc- 
cessful at  the  polls  by  a  narrow  margin.  The  Democrats,  under 
the  leadership  of  Mr.  Bryan,  stood  for  national  bimetallism  at 
the  ratio  of  16  to  i.  Four  years  later,  on  March  14,  1900, 
Congress  enacted  a  law  known  as  the  gold  standard  law, 
by  which  the  United  States  definitely  established  gold  as  the 
pecuniary  unit. 

The  operation  of  Gresham's  law  was  to  be  prevented  by  the 
"compensatory  action"  of  a  double  standard.  Those  who  ad- 
vocated the  retention  of  the  bimetallic  standard  looked  to  what 
was  known  as  the  compensatory  action  to  prevent  a  variation  of 
the  market  from  the  mint  ratio,  and  thus  to  prevent  the  familiar 
operation  of  Gresham's  law.  In  brief,  the  argument  is  as 
follows: 

With  the  mint  ratio  at  16  to  1,  if  silver  should  be  worth  in 
the  market,  say,  16.1  to  i,  silver  would  be  overvalued  at  the 
mint  and  gold  undervalued.  Silver  would  accordingly  be  in 
increased  demand  at  the  mint  and  gold  in  decreased  demand, 
with  the  result  that  the  value  of  silver  would  be  raised  and  the 


78  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

value  of  gold  lowered,  which  would  operate  to  restore  the 
ratio  to  i6  to  i.  And  if  perchance  the  market  ratio  should 
become  15.9  to  i,  then  gold  would  be  overvalued  at  the  mint 
and  silver  undervalued,  whereupon  an  increased  demand  foi 
gold  and  a  decreased  demand  for  silver  would  bring  the  ratio 
back  to  16  to  I.  Since  this  compensatory  action  would  work 
immediately  and  automatically  as  soon  as  any  variation  between 
market  and  mint  ratio  appeared,  the  readjustment  would  be 
practically  instantaneous,  thus  effectively  preventing  the  opera- 
tion of  Gresham's  law.  Scientific  writers  on  the  subject  saw 
clearly  enough  that  an  international  bimetallic  system  was 
necessary  to  a  successful  operation  of  this  compensatory  action; 
for  if  France,  for  instance,  had  a  ratio  of  15  to  i,  whereas  the 
United  States  had  a  ratio  of  16  to  i,  it  would  pay  bullion 
dealers  to  ship  silver  from  the  United  States  to  France,  where  a 
higher  coinage  value  existed.  Many  economists  have  con- 
tended, however,  that  with  international  bimetallism  the 
compensatory  action  would  at  all  times  insure  a  practical 
equalization  of  mint  and  market  ratios. 

During  the  protracted  struggle  over  bimetallism,  a  num- 
ber of  international  conferences  were  held  with  a  view  to 
securing  the  adoption  of  an  international  bimetallic  standard. 
These  conferences,  however,  came  to  naught.  National 
jealousy  was  manifested  in  connection  with  the  unit  to  be 
adopted — whether  mark,  franc,  pound,  or  dollar  should  be 
chosen.  In  all  these  conferences,  moreover,  England  was 
apathetic  because  she  had  for  a  great  many  years  possessed 
a  single  gold  standard  and  was  on  the  whole  well  satisfied  with 
the  results  attained  under  it;  indeed,  there  was  good  reason  for 
believing  that  England's  commercial  and  financial  supremacy 
was  in  no  small  degree  due  to  the  stability  and  certainty  of 
her  monetary  system. 

It  remains  to  inquire  whether,  with  international  bimetallism, 
the  compensatory  action  would  have  prevented  the  operation 
of  Gresham's  law  and  in  the  face  of  all  contingencies  have 
maintained  a  parity  of  market  and  mint  ratio.  Reference 
to  the  table  on  page  82,  which  gives  the  figures  of  relative 


REGULATION  OF  METALLIC  CURRENCY  79 

production  of  gold  and  silver  over  a  long  period  of  years,  indi- 
cates that  the  supplies  of  these  metals  are  dependent  upon 
mining  conditions.  While  in  the  years  following  1849,  for 
example,  there  was  no  noteworthy  change  in  the  relative  demand 
for  gold  and  silver,  there  was  a  tremendous  increase  in  the 
supply  of  gold  because  of  the  discovery  of  the  rich  gold  fields 
of  California  and  Australia.  The  table  on  page  83  indi- 
cates the  resulting  effect  upon  the  commercial  ratio  of  the  two 
metals. 

If  there  were  but  minor  variations  in  the  supply  of  the  two 
metals,  it  is  possible  that  the  compensatory  action  would 
operate  to  maintain  the  commercial  ratio  'of  gold  and  silver 
at  a  parity  with  the  mint  ratio.  It  is  hardly  probable,  how- 
ever, that  the  system  would  work  under  all  circumstances.  If 
the  gold  mines  should  be  completely  exhausted  and  if  at  the 
same  time  the  output  of  silver  should  increase  at  a  rate 
hitherto  undreamed  of,  it  is  doubtful,  to  say  the  least,  if  the 
compensatory  action  could  prevent  a  fall  in  the  relative  value 
of  silver. 

V.    WHY  GOLD  BECAME  THE  SINGLE 
STANDARD 

The  reason  why  gold  rather  than  silver  has  everywhere  been 
chosen  as  the  single  standard  is  usually  said  to  be  the  "inherent 
superiority  of  gold"  for  the  purpose  in  hand.  It  will  be  of 
interest  to  consider  this  statement  in  the  light  of  the  data  pre- 
sented in  the  tables  on  pages  82  and  83. 

After  the  coinage  law  of  1834,  which  fixed  the  mint  ratio 
at  16  to  I,  silver  was  undervalued  at  the  mint  and  hence  it  was 
improfitable  to  have  it  coined.  The  "crime  of  1873"  con- 
sisted, as  noted  above,  in  eliminating  the  standard  silver  dollar 
from  among  the  list  of  coins  that  could  be  struck  at  the  United 
States  mint.  Had  the  silver  dollar  not  been  undervalued  at  the 
mint — owing  not  to  any  inherent  inferiority  of  silver  but  merely 
to  the  legislation  which  fixed  the  mint  ratio  at  16  to  i  when  the 
market  ratio  was  about  15.7  to  i — it  is  altogether  improbable 
that  it  would  have  been  demonetized.    If,  on  the  other  hand, 


8o  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

rich  silver  mines,  rather  than  gold  mines,  had  been  discovered 
in  1849,  and  the  commercial  ratio  had  in  consequence  changed 
to,  say,  17  to  I,  it  would  have  been  unprofitable  to  coin 
gold.  Under  these  circumstances  a  revision  of  the  coinage 
laws  might  conceivably  have  resulted  in  the  demonetization 
of  gold. 

In  any  event,  it  was  the  great  increase  in  the  output  of  silver 
after  1874,  occasioned  by  the  discovery  of  the  Comstock  lode, 
that  brought  the  silver  issue  to  the  front.  In  the  absence  of 
this,  or  similar  discoveries,  the  silver  issue  might  never  have 
arisen;  for  so  long  as  silver  was  worth  more  in  the  form  of 
bullion  than  as  coin  no  one  had  any  interest  in  presenting  it  at 
the  mint. 

The  controversy  over  bimetallism  ended>  as  was  noted 
above,  with  the  presidential  campaign  of  1896.  Reference  to 
the  statistics  of  production  of  gold  after  1896  and  to  the  price 
movement  (as  depicted  on  p.  31)  will  serve  to  indicate  one  reason 
why  the  bimetallic  controversy  has  not  been  resumed.  If  the 
cyanide  process  had  not  been  developed  (for  it  is  the  chief 
cause  of  the  great  increase  in  gold  production  during  the  past 
thirty  years),  if  the  Klondike  and  South  African  fields  had  not 
been  opened,  and  if  prices  had  continued  to  fall  after  1896  as 
they  did  in  the  previous  decade,  it  is  not  at  all  improbable 
that  bimetallism  would  have  been  a  recurrent  issue  in  American 
poUtics. 

The  rise  in  the  price  of  silver  since  igi^  may  cause  a  renewed 
agitation  for  bimetallism.  With  the  great  change  in  the  com- 
mercial ratios  of  gold  and  silver  since  the  outbreak  of  the  Great 
War,  the  possibility  of  a  restoration  of  bimetallism  has  again 
received  some  attention.  The  great  increase  in  the  value  of 
silver  was  due  to  three  factors:  first,  a  decline  in  the  production 
of  silver  bullion,  owing  to  labor  shortage  and  unsettled  condi- 
tions in  leading  silver-producing  regions;  second,  an  enormous 
increase  in  the  demand  for  the  metal  by  the  silver-using  countries 
of  the  Orient,  occasioned  by  favorable  trade  balances  and  the 
rising  price  level,  which  necessitated  an  increased  volume  of 
currency  in  active  circulation;  and  third,  the  rising  price  level 


REGULATION  OF  METALLIC  CURRENCY  8l 

in  all  occidental  nations,  which,  as  in  the  Orient,  has  required 
a  great  increase  in  the  volume  of  subsidiary  silver  currency. 

The  rise  in  the  relative  value  of  silver  from  39.84  to  i  in 
1 91 5  to  less  than  16  to  i  in  the  fall  of  19 19  marks  the  most 
rapid  fluctuation  on  record  in  the  commercial  ratio  of  the  two 
metals.  The  return  to  16  to  i  has  created  in  some  quarters  a 
sentimental  agitation  for  the  restoration  of  the  silver  dollar, 
which  appears  to  its  devotees  thus  to  have  vindicated  itself 
despite  all  hostile  legislation.  Added  to  this  sentimental  argu- 
ment is  the  practical  one,  that  there  is  now  an  insufficiency  of 
"specie"  to  support  the  vast  credit  and  paper-money  circula- 
tions that  have  arisen  from  the  exigencies  of  war  finance.  An 
increase  of  specie  reserves  may  therefore  possibly  be  sought  by 
way  of  the  restoration  of  bimetallism  and  the  stimulation  of 
the  production  of  both  gold  and  silver. 

Indeed,  in  a  speech  before  Congress  on  February  9,  1920, 
Senator  Thomas,  of  Colorado,  urged  the  establishment  of 
international  bimetallism  at  the  ratio  of  16  to  i,  stating  that 
"events  have  confounded  the  contentions  of  the  advocates 
of  gold  standard  supremacy,  justified  the  arguments  of  the 
defenders  of  silver,  and  confirmed  the  wisdom  of  the  theory  of 
bimetalUsm."  He  declared  that  the  "whirligig  of  time"  has 
made  applicable  to  gold  the  same  arguments  that  were  used 
against  silver  in  the  nineties;  gold  rather  than  silver  now 
requires  the  stead)dng  influence  of  an  international  agreement. 
He  pointed  out  that  the  volume  of  paper  money  in  the  world  is 
out  of  all  proportion  to  the  volume  of  specie,  thus  causing  the 
tremendous  depreciation  of  the  foreign  exchanges;  and  con- 
cluded that  "we  must  stimulate  international  confidence  in 
modern  currency  systems,  make  the  problem  of  deflation  com- 
paratively easy  and  re-establish  the  regime  of  a  saner  and  more 
dependable  monetary  medium."  Since  February,  1920,  how- 
ever, silver  has  declined  from  a  maximum  price  of  $1.38  to 
less  than  $1 .00  per  ounce,  owing  mainly  to  a  business  depression 
in  the  Orient,  attended  by  falling  prices  and  a  collapse  of 
speculation  in  silver.  Accordingly,  a  renewal  of  the  bimetallic 
agitation  now  appears  much  less  probable. 


82 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


VI.    PRODUCTION  OF  GOLD  AND  SILVER  IN  THE 
WORLD  SINCE  THE  DISCOVERY  OF  AMERICA* 


Gold 

Silver 

Annuat,  Average  for  Period 

Ankuai.  Average  for  Period 

Pzuoo 

Coining  Value  in 

Coining  Value  in 

Fine  Ounces 

Standard  Silver 
Dollars 

Fine  Ounces 

Standard  Silver 
Dollars  ■ 

1493-1520. . 

186,470 

$           3.855,000 

1,511,050 

$           1,954,000 

1521-1544.. 

230,194 

4,759,000 

2,899,930 

3,740,000 

1545-1560. . 

273,596 

3,656,000 

10,017,940 

12,952,000 

156I-I580. , 

219,906 

4,546,000 

9,628,925 

12,450,000 

I58I-I600. . 

237,267 

4,905,000 

13,467,635 

17,413,000 

I60I-1620. . 

273,918 

5,662,000 

13,596,235 

17,579,000 

I62I-I640. . 

266,845 

5,516,000 

12,654,240 

16,361,000 

164I-I660. . 

281,995 

5,828,000 

",776,545 

15,226,000 

I66I-I680.. 

297,709 

6,154,000 

10,834,550 

14,008,000 

I68I-I700. . 

346,09s 

7,154,000 

10,992,085 

14,212,000 

1701-1720.. 

412,163 

8,520,000 

11,432,540 

14,781,000 

I72I-I740. . 

613,422 

12,581,000 

13,863,080 

17,924,000 

I 741-1760.. 

791,211 

16,356,000 

17,140,612 

22,162,000 

I76I-I780.. 

665,666 

13,761,000 

20,985,591 

27,133,000 

1781-1800.. 

571,948 

11,823,000 

28,261,779 

36,540,000 

I80I-I8IO. . 

571,563 

11,815,000 

28,746,922 

37,168,000 

I8II-I820. . 

367,957 

7,606,000 

17,385,755 

22,479,000 

I82I-I830. . 

457,044 

9,448,000 

14,807,004 

19,144,000 

1 831-1840. . 

652,291 

13,484,000 

19,175,867 

24,793,000 

1841-1850. . 

1,760,502 

36,393,000 

25,090,842 

32,440,000 

1851-1855.. 

6,410,324 

132,513,000 

28,488,597 

36,824,000 

I856-I860. . 

6,485,262 

134,083,000 

29,095,428 

37,618,000 

1861-1865.. 

5,949,582 

122,989,000 

35401,972 

45,772,000 

I866-I870. . 

6,270,086 

129,614,000 

43,051,583 

55,663,000 

I87I-I875.. 

5,591,014 

115,577,000 

63,317,014 

81,864,000 

I876-I880. . 

S,543,"o 

114,586,000 

78,775,602 

101,851,000 

I88I-I885.. 

4,794,755 

99,116,000 

92,003,944 

118,955,000 

I886-I890. . 

5,461,282 

112,895,000 

108,911,431 

140,815,000 

I 891-1895.. 

7,882,565 

162,946,000 

157,581,331 

203,742,000 

I 896-1 900. . 

12,446,939 

257,301,100 

165,693,304 

214,229,700 

1901-1905.. 

15,606,730 

322,619,800 

167,995,408 

217,206,200 

1906 

19,471,080 

402,503,000 

165,054,497 

213,403,800 

1907 

19,977,260 

412,966,600 

184,206,984 

238,166,600 

1908 

21,422,244 

442,836,900 

203,131,404 

262,634,500 

1909 

21,965,111 

454,059,100 

212,149,023 

274,293,700 

I9I0 

22,022,180 

455,239,100 

221,715,673 

286,662,700 

I9II 

22,348,313 

461,980,500 

226,192,923 

292,451,500 

I9I2 

22,549,335 

466,136,100 

224,310,654 

290,017,800 

I9I3 

22,249,596 

459,939,900 

223,907,843 

289,497,000 

I9I4 

21,240,416 

439,078,260 

168,452,942 

217,797,743 

19IS 

22,674,568 

468,724,918 

184,204,745 

238,163,710 

I9I6 

21,970,788 

454,176,500 

168,843,000 

218,302,060 

I9I7 

20,289,546 

419,422,100 

174,187,800 

225,212,509 

I9I8 

18,427,232 

380,924,700 

197,394,900 

255,217,648 

Total.. 

841,599,968 

$17,397,417,278 

12,222,260,479 

$15,802,518,570 

*  From  Annual  Report  of  Director  of  the  Mint,  1918. 


REGULATION  OF  METALLIC  CURRENCY 


83 


VII.     COMMERCIAL  RATIO  OF  GOLD  AND  SILVER 
SINCE  1687' 


Year 


687. 
690. 
695- 

7CXD. 

705- 

710. 
712. 

715- 

720. 

725- 
730- 

735- 
740. 

745- 
750- 
755- 
760. 

765. 
770. 

775- 
780. 

785. 
790. 
795- 

8CX3. 

801. 
802. 
803. 
804. 
80s. 
906. 
807. 
808. 
809. 
810. 
811. 

8l2. 

813. 

814. 

815. 

816. 

817. 
818. 
819. 
820. 
821. 
822. 
823. 


Ratio 


Year 


1824. 
1825. 
1826. 
1827. 
1828. 
1829. 
1830. 
1831. 
1832. 
1833. 
1834. 
1835- 
1836. 
1837. 
1838. 
1839. 
1840. 
1841. 
1842. 

1843. 
1844. 

1845. 
1846. 
1847. 


1850. 
1851. 
1852. 
1853. 
1854. 
1855- 
1856. 

1857- 
1858. 

1859. 
i860. 
1861. 
1862. 
1863. 
1864. 
1865. 
1866. 
1867. 
1868. 
1869. 
1870. 
1871. 


Ratio 


IS 

82 

IS 

70 

IS 

76 

IS 

74 

15 

78 

IS 

78 

IS 

82 

IS 

72 

IS 

73 

15 

93 

15 

73 

IS 

80 

IS 

72 

IS 

83 

IS 

8S 

IS 

62 

IS 

62 

IS 

70 

IS 

87 

IS 

93 

IS 

8S 

IS 

92 

IS 

90 

IS 

80 

IS 

8S 

IS 

78 

IS 

70 

IS 

46 

IS 

59 

IS 

33 

15 

33 

IS 

38 

15 

38 

IS 

27 

IS 

38 

IS 

19 

IS 

29 

I 

IS 

SO 

IS 

3S 

IS 

37 

I 

IS 

38 

I 

IS 

44 

I 

IS 

43 

I 

15 

S7 

15 

59 

15 

60 

IS 

57 

IS 

70 

Year 


[872. 
1873. 
[874. 
t87S. 
[876. 

t877. 
[878. 

[879. 

1880. 

Ji. 

52. 

t883. 


[887. 
[888. 
[889. 
[890. 
[891. 
[892. 
[893. 
[894. 
1895. 
1896. 
1897. 
1898. 
1899. 
t900. 
1 901. 
1902. 
1903. 
[904. 

":90s- 
[906. 
[907. 
1908. 
[909. 
[910. 
[911. 
[912. 

1913- 
1914. 
t9iS- 
1916. 
[917. 
1918. 
1919. 


Ratio 


15.63 
15  92 
16.17 
16.59 
17.88 
17.22 

1794 
18.40 
18.  OS 
18.16 
18.19 
18.64 
18.57 
19.41 
20.78 
21.13 
21.99 
22. 10 
19.76 
20.92 
23.72 
26.49 
32.56 
3160 
30.66 
34.20 
35  03 
34-36 
33-33 
34-68 

39  15 
38.10 
35.70 
33.87 
30.54 
31.24 
38.64 
39-74 
38.22 

38.33 
33.62 

34.19 
37-37 
39  84 
30.11 
23.09 
21.00 
17.00* 


*  Estimated.    Late  in  igig  the  ratio  became  less  than  16  to  i.    It  has  since  risen  to 
about  34  to  I. 

'  From  Annual  Report  of  Director  of  the  Mint,  1919,  p.  155. 


84  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Vm.    THE  REGULATION  OF  SUBSIDIARY  METALLIC 
CURRENCY 

The  subsidiary  metallic  currency  of  the  United  States  con- 
sists of  the  silver  dollar,  half-dollar,  quarter,  dime,  nickel,  and 
one-cent  piece.  All  of  these  coins  now  have  a  face  value  greater 
than  their  value  in  the  form  of  bullion.  Such  coins  are  called 
token  coins.  They  are  maintained  at  par  with  gold,  the  stand- 
ard metal,  by  a  process  of  redemption,  direct  in  the  case  of  cents, 
nickels,  dimes,  quarters,  and  half-dollars,  indirect  in  the  case 
of  silver  dollars.  The  following  are  the  redemption  provisions 
of  the  United  States  currency  laws: 

Fractional  silver  coins — ^half-dollars,  quarters,  and  dimes — 
and  minor  coins — nickels  and  cents — may  be  presented,  in 
sums  or  multiples  of  twenty  dollars,  to  the  Treasurer  of  the 
United  States  or  to  an  Assistant  Treasurer  for  redemption  or 
exchange  into  lawful  money.  Being  redeemable  in  gold,  they 
are  as  good  as  gold. 

Fractional  silver  coins  were  originally  of  proportional  weight 
with  the  silver  dollar;  but  since  1853  they  have  contained 
about  7  per  cent  less  silver.  The  nominal  value  of  two  half- 
dollars,  four  quarters,  and  ten  dimes,  respectively,  is  obviously 
equal  to  one  gold  dollar.  The  value  of  the  bullion  content 
varies  with  the  fluctuations  in  the  price  of  silver  bulUon. 

The  nickel,  or  five-cent  piece,  is  a  combination  of  copper  and 
nickel — three-fourths  copper  and  one-fom"th  nickel.  The  cent 
is  composed  of  95  per  cent  copper  and  5  per  cent  tin  and  zinc. 

Both  fractional  silver  coins  and  the  minor  coins  are  struck 
only  as  the  needs  of  trade,  as  e^ddenced  by  the  demand  for 
"change"  at  the  banks,  require.  The  government  purchases 
the  bullion  required  in  the  market;  and  the  profit — called 
seignorage — which  arises  fsom  coining  dollars  whose  face 
value  is  greater  than  that  of  the  bullion  content,  goes  to  the^ 
government. 

The  silver  dollar  is  still  designated  a  standard  coin  of  the 
United  States,  although  since  1873  its  coinage  has  been  limited, 
and  since  1900  it  has  been  to  all  intents  and  purposes  definitely 


REGXJLATION  OF  METALLIC  CURRENCY  85 

in  the  position  of  a  subsidiary  coin.  Since  1904  no  silver  dollars 
have  been  coined.  But  because  of  the  historical  importance 
of  silver  and  the  persistency  of  long-established  custom,  the 
silver  dollar  is  still  called  a  standard  coin,  and  is  not  directly 
redeemable  in  gold.  A  system  of  indirect  redemption  has  been 
established,  however,  which  has  thus  far  proved  quite  as 
effective  as  would  specific  redemption  in  gold.  In  all  payments 
due  to  itself,  the  Treasury  will  accept  silver  on  an  equality  with 
gold,  and  in  all  treasury  disbursements  gold  is  paid  out  whenever 
that  metal  is  desired.  In  no  case  does  the  Treasury  force  silver 
upon  an  unwilling  person.  Moreover,  it  is  provided  by  the 
Currency  Act  of  1900  that  silver  shall  be  maintained  at  a  parity 
with  gold,  and  that  it  shall  be  the  duty  of  the  Secretary  of  the 
Treasury  to  maintain  such  parity.  In  case  the  foregoing 
method  of  indirect  redemption  did  not  prove  efficacious  the 
Secretary  would  therefore  be  obliged  to  resort  to  direct  means, 
and  redeem  silver  dollars  in  gold. 

IX.    LEGAL  TENDER  PROVISIONS  FOR  METALLIC 
CURRENCY 

The  purpose  of  legal  tender  is  to  legalize  the  settlement  of 
obligations.  If  business  is  to  be  conducted  both  with  dispatch 
and  certainty  and  if  endless  disputes  are  to  be  avoided  over  the 
kind  and  quality  of  the  thing  which  is  tendered  in  payment  of 
debts,  there  must  be  some  lawful  means  of  payment.  Money 
has  therefore  been  given  the  quality  of  legal  tender.  It  is  to 
be  noted,  however,  that  the  tender  of  money  in  payment  of  an 
obligation  may  be  refused  by  the  person  to  whom  the  money  is 
proffered,  without  an  automatic  cancellation  of  the  debt.  The 
law  holds  that  the  tender  must  be  made  continuous.  The 
payment  of  interest  on  the  obligation,  however,  automatically 
ceases  with  the  tender  of  lawful  money  and  certain  legal  advan- 
tages are  lost  to  the  creditor. 

Gold  coin  is  legal  tender  at  its  nominal  or  face  value  for  all 

.  debts,  public  and  private,  when  not  below  the  standard  weight 

and  limit  of  tolerance  prescribed  by  law;    and  when  below 


86  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

such  standard  weight  and  limit  of  tolerance  it  is  legal  tender  in 
proportion  to  its  weight. 

Silver  dollars  are  legal  tender  at  their  nominal  or  face  value 
in  payment  of  all  debts,  public  and  private,  without  regard 
to  the  amount,  except  where  otherwise  expressly  stipulated  in 
the  contract. 

Fractional  silver  is  legal  tender  for  amounts  not  exceeding 
ten  dollars  in  .any  one  payment. 

The  minor  coins  of  nickel  and  copper  are  legal  tender  to  the 
extent  of  twenty-five  cents. 

QUESTIONS  FOR  DISCUSSION 

I.     COINAGE 

1.  Which  would  be  more  difficult  to  detect,  impure  or  underweight 
pieces  of  uncoined  metal  ?  Which  would  be  easier  to  adjust  to 
the  satisfaction  of  traders  ? 

2.  In  weighing  gold,  how  much  difference  would  it  make  if  the  scales 
weighed  an  oimce  light  ? 

3.  What  are  the  objections  to  a  private  monopoly  of  coinage? 

4.  Which  of  the  various  objects  sought  in  a  good  coinage  system  is 
the  most  difficult  of  attainment  ? 

5.  Enumerate  the  specific  conditions  necessary  to  the  operation 
of  Gresham's  law. 

6.  If  you  had  the  opportunity  of  paying  a  debt  to  a  friend  in  full- 
weight  or  light-weight  coins,  which  woidd  you  use?  which  in 
paying  a  debt  to  a  foreigner  ? 

7.  If  a  bullion  dealer  wished  to  melt  up  coins,  wovdd  he  use  new  or 
abraded  coins  ? 

8.  Mr.  A  takes  1,000  ounces  of  gold  bullion  to  the  mint:  (o)  it  is 
assayed,  parted,  and  refined;  (b)  standardized  by  the  adding  of 
copper;  (c)  manufactiured  into  coin.  Who  assumes  these  various 
charges? 

9.  What  is  meant  by  free  coinage  ?  by  gratuitous  coinage  ? 

10.  Do  we  have  both  free  and  gratuitous  coinage  of  gold  in  the 
United  States  ? 


REGULATION  OF  METALLIC  CURRENCY  87 

11.  Mr.  A  takes  to  the  United  States  mint  20,000  ounces  of  gold 
.  950  fine.  The  impurities  are  removed  and  the  gold  is  standard- 
ized and  coined.    How  much  will  A  receive  from  the  mint  ? 

12.  If  in  the  preceding  problem  the  .050  is  copper,  how  many 
standard  dollars  would  A  receive? 

13.  Mr.  B  takes  10,000  ounces  of  British  gold  coins,  which  are  eleven- 
twelfths  fine,  to  the  United  States  mint.  How  many  American 
dollars  would  he  receive? 

14.  What  is  meant  by  the  "tolerance  of  the  mint"?  Why  is  this 
permitted  ? 

15.  What  is  the  purpose  of  the  "trial  of  the  pyx"?  of  the  Assay 
Commission  ? 

16.  What  is  meant  by  "minimum  circulating  weight"  ? 

17.  Who  should  suffer  the  loss  when  a  coin  is  foimd  to  be  legally 
uncurrent  on  account  of  abrasion  ?    Why  ? 

18.  What  sort  of  coins  in  the  United  States  is  most  likely  to  be 
coimterf  eited  ? 

19.  What  devices  and  methods  are  used  to  prevent  counterfeiting? 

20.  What  bearing  have  the  following  upon  the  possible  variations  in 
value  of  coined  and  uncoined  gold:  (c)  tolerance  of  the  mint; 
(b)  minimum  currency;  (c)  brassage;  (d)  gratuitous  coinage; 
(e)  free  coinage  ? 

21.  Do  you  think  that  Macaulay  overemphasizes  the  social  evils  of  a 
bad  currency  ? 

n.      BIMETALLISM 

22.  How  do  you  account  for  the  fact  that  bimetallism  was  every- 
where an  accepted  principle  in  the  sixteenth  and  seventeenth 
centuries  ? 

23.  If  the  coinage  or  mint  ratio  is  16  to  i  and  the  market  ratio  15 . 5  to 
I,  show  what  would  happen  under  the  operation  of  Gresham's 
law. 

24.  Between  1792  and  1834  the  mint  ratio  in  the  United  States  was 
15  to  I.  Consult  the  table  of  conunercial  ratios  of  gold  and 
silver  and  indicate  what  must  have  occiirred. 

25.  In  1834  the  mint  ratio  was  changed  to  16  to  i.  What  must  have 
ocoured  then,  in  view  of  the  market  ratio  ? 


88  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

26.  Suppose  the  "crime  of  '73"  had  been  committed  in,  say,  i860: 
when  would  it  have  been  discovered?  Suppose  the  Ciurrency 
Act  of  1873  had  been  passed  a  year  later:  could  the  silver  dollar 
then  have  been  omitted,  without  controversy,  from  the  list  of 
coins  that  could  be  minted  ? 

27.  Three  causes  may  be  assigned  for  the  growth  of  an  agitation  for 
monometallism:  (o)  the  decHne  of  mercantilism;  (b)  the  im- 
provement of  coinage  technique  and  the  consequent  revelation 
of  the  evils  of  bimetallism  in  connection  with  international  opera- 
tions; (c)  the  increase  in  the  quantity  of  precious  metals  and 
hence  in  the  supply  of  currency.  Which  do  you  think  has  been 
most  important  ?  (Consult  the  tables  on  pp.  82  and  83  in  con- 
nection with  the  principal  dates  of  the  bimetallic  controversy.) 

28.  Study  the  table  showing  the  commercial  ratios  of  gold  and  silver 
and  see  if  you  can  find  a  reason  for  the  demonetization  of  silver 
rather  than  gold.  Do  you  attribute  it  to  the  inherent  inferiority 
of  silver  ? 

29.  "Gold  has  been  proved  to  be  the  most  satisfactory  metal  for 
monetary  uses."  Does  this  apply  to  its  use  as  a  medium  of 
exchange,  as  a  pecuniary  unit  of  calculation,  or  as  a  standard  for 
deferred  payments  ? 

30.  Do  the  statistics  of  production  of  gold  show,  as  a  matter  of 
fact,  that  gold  is  more  likely  to  prove  of  stable  value  than 
silver  ? 

31.  If  the  annual  gold  production  had  declined  after  1896,  rather 
than  increased,  might  our  subsequent  monetary  history  have 
been  different  ?    If  so,  how  ? 

32.  How  do  you  account  for  the  great  rise  in  the  value  of  silver  since 
1914? 

33.  The  standard  silver  dollar  contains  371 .25  grains  of  pure  silver. 
The  mint  price  is  $1 .  29  per  ounce.  Look  up  the  latest  quotation 
of  the  price  of  silver  bullion  in  the  financial  pages  of  the  daily 
press  or  in  the  financial  journals  and  compute  the  present  bullion 
value  of  a  silver  dollar. 

34.  What  would  happen  to  our  monetary  system  if  silver  bullion 
should  become  worth  $1 .  30  an  ounce  ?  $1 .  40  an  ounce  ? 

35.  Would  a  restoration  of  bimetallism  nec^gs^rjly  increase  the 
total  quantity  of  spec;e  '^^  tj^^  werl4  ? 


REGULATION  OF  METALLIC  CURRENCY  89 

in.      THE  REGULATION   OF   FRACTIONAL  SILVER   CURRENCY 

36.  After  1850  fractional  silver  coins  disappeared  from  circulation. 
Why  did  they  not  disappear  earlier  ?  (Consult  tables  on  pp.  82 
and  83.) 

37.  An  act  of  1853  reduced  the  weight  of  fractional  silver  coins 
by  about  7  per  cent.  What  would  be  the  result  of  such  a 
reduction  ?     (Consult  the  table  of  commercial  ratios.) 

38.  When  fractional  silver  coins  were  thus  reduced  in  weight,  what 
steps  would  have  to  be  taken  to  prevent  them  from  driving  gold 
out  of  circulation  ? 

39.  Is  there  any  good  reason  at  the  present  time  for  making  frac- 
tional silver  pieces  of  less  proportional  weight  than  the  silver 
dollar?  At  what  price  per  ounce  for  silver  bullion  would  it 
pay  to  melt  up  fractional  silver  coins? 

40.  How  is  the  parity  of  the  fractional  silver  pieces  maintained? 

41.  What  is  meant  by  legal  tender?  Is  it  necessary  that  money  be 
legal  tender  in  order  to  pass  current  ? 

42.  X  owes  Y  ten  dollars,  and  the  debt  is  due.  They  are  riding 
together  on  a  railroad  train.  Seeing  a  bandit  entering  the  car,  X 
says  to  Y,  "Here  is  the  ten  dollars  I  owe  you."  What  would 
you  say  if  you  were  Y  ? 

43.  Would  contracts  Uke  the  following  be  binding  in  the  United 
States:  (o)  "I  promise  to  pay  for  value  received,  one  thousand 
dollars  in  lawful  money,  except  in  silver"?  (b)  "I  promise  to 
pay  for  value  received,  one  thousand  dollars  in  lawful  money, 
except  in  gold"?  (c)  "I  promise  to  pay  for  value  received,  one 
thousand  silver  dollars"?  (d)  "I  promise  to  pay  for  value 
received  two  thousand  fifty-cent  pieces"?  (e)  "I  promise  to 
pay  for  value  received,  one  thousand  bushels  of  wheat"? 

44.  Why  limit  the  legal  tender  power  of  the  silver  dollar  ?  Why  give 
any  legal  tender  power  to  fractional  silver  coins  ? 

REFERENCES  FOR  FURTHER  READING 

Holdsworth,  John  Thorn:  Money  and  Banking,  chap.  iii. 
Jevons,  W.  S. :  Money  and  the  Mechanism  of  Exchange,  chaps,  v. 
vi,  and  vii. 

Laughliu,  J.  Laurence:  Principles  of  Money,  chaps,  30  and  xii. 


go  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Moulton,  Harold  G. :  Principles  of  Money  and  Banking,  chaps, 
ii,  iv,  and  vi. 

Phillips,  Chester  A. :  Readings  in  Money  and  Banking,  chaps,  vi 
and  vii. 

Scott,  William  A.:   Money  and  Banking,  chap.  ii. 

White,  Horace:  Money  and  Banking,  Book  I,  chaps,  ii-vi. 


CHAPTER  VII 

THE  REGULATION  OF  GOVERNMENT  PAPER 
CURRENCY 

Paper  money  is  of  so  many  difierent  kinds,  and  the  prind- 
ples  of  regulation  involved  are  so  numerous  and  diverse  that 
a  clean-cut  treatment  of  the  subject  is  difficult.  A  broad  dis- 
tinction may  be  made,  however,  between  government  and 
bank  paper  money.  The  former  is  issued  by  the  state  for  the 
purpose  of  meeting  current  obligations  when  the  Treasury  is 
empty,  or  to  provide  an  inexpensive  and  convenient  medium  of 
exchange  by  substituting  in  the  channels  of  circulation  paper 
bills  for  metallic  money;  the  latter  is  issued  by  privately 
managed  institutions  which  are  seeking  private  profit  from 
the  making  of  loans.  The  principles  of  regulation  underlying 
these  two  forms  of  paper  cm-rency  are  fundamentally  different, 
and  they  cannot  be  satisfactorily  treated  together.  Since  the 
regulation  of  bank  paper  is  tied  up  with  the  whole  theory  of 
credit  and  banking,  treatment  of  it  is  reserved  for  subsequent 
discussion.* 

Government  paper  is  of  three  main  types:  (i)  mere  repre- 
sentative paper;  (2)  convertible  fiduciary  paper;  and  (3)  incon- 
vertible or  fiat  currency.  Representative  money  is  backed 
dollar  for  doUar  by  specie,  and  the  paper  certificates  which 
circulate  are  merely  claim  checks  to  an  equivalent  in  coin.  Such 
paper  gives  rise  to  no  problems  of  regulation.  Convertible 
fiduciary  paper  is  exchangeable  for  specie,  but  is  not  covered  by 
a  coin  reserve  of  100  per  cent.  Unlike  representative  paper, 
it  involves  an  element  of  trust  or  credit  and  affords  a  means 
of  expanding  the  quantity  of  money  beyond  what  is  possible 
with  the  use  of  specie  alone.  Numerous  devices  have  been 
developed,  as  we  shall  see,  by  means  of  which  redeemability  may 

*  See  chapters  on  commercial  banking  below. 

91 


92  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

be  insured  without  a  full  specie  reserve,  and  there  has  been  a 
long-continued  discussion  as  to  the  most  effective  means  for  the 
purpose,  resulting  in  the  development  of  a  fairly  definite  body 
of  principles.  Similarly,  there  has  been  a  prolonged  controversy 
over  the  advantages  and  the  practicability  of  inconvertible  paper 
currency,  or  what  may  be  called  the  "fiat"  or  paper  standard 
of  value.  This  controversy  has  disclosed  some  of  the  most  inter- 
esting fallacies  in  the  whole  realm  of  political  economy,  and 
the  experiences  of  mankind  with  irredeemable  paper  money  have 
been  among  the  most  costly  lessons  that  society  has  ever  had  to 
learn.  The  lesson  has,  morever,  even  yet  not  been  thoroughly 
learned. 

I.    IRREDEEMABLE  PAPiER  OR  FIAT  CURRENCY 

The  history  of  inconvertible  or  fiat  paper  currency  is  prac- 
tically contemporaneous  with  that  of  the  controversy  over 
bimetallism;  indeed  the  underlying  cause  of  the  advocacy  of 
fiat  paper  money  is  virtually  identical  with  that  underlying 
the  popular  agitation  for  the  retention  of  bimetallism,  namely, 
the  desire  for  a  plentiful  supply  of  cheap  currency. 

There  have  been  numerous  instances  in  this  and  other 
countries  of  the  use  of  irredeemable  paper  money.  While  there 
have  always  been  many  who  have  believed  that  irredeemable 
paper  is  the  ideal  money  at  all  times,  the  actual  issue  of  such 
currency  has  usually  been  the  result  of  pressing  financial  needs 
on  the  part  of  governments;  and  the  issuers  have  usually  sought 
to  justify  their  acts  as  emergency  measures,  particularly  as  a 
means  of  meeting  the  financial  exigencies  of  war.  In  our  own 
history,  in  addition  to  the  early  Colonial  and  Revolutionary 
experiences,  both  the  South  and  the  North  during  the  Civil 
War  issued  large  quantities  of  paper  with  which  to  meet  the 
immediate  requirements  of  government ;  and  in  the  recent  Euro- 
pean struggle,  paper  money,  issued  through  the  medium  of 
central  banks  controlled  by  the  various  governments,  played 
an  important  role  in  meeting  the  enormous  financial  require 
ments  of  th^  Actions  involved. 


REGULATION  OF  PAPER  CURRENCY  93 

The  striking  feature  of  the  history  of  paper  money  is  that 
once  an  issue  is  started  it  becomes  well-nigh  impossible  to 
prevent  an  alrnost  indefinite  increase.  Let  the  first  step  be  ever 
so  hesitant,  when  once  it  has  been  taken  other  issues  are  almost 
certain  to  follow  in  rapid  succession  until  the  entire  monetary 
system  is  deranged  and  the  stability  of  the  pecuniary  unit  in 
which  prices  are  expressed  is  completely  undermined.  The 
effects  of  an  issue  of  irredeemable  paper  currency  have  always 
been  disastrous  in  the  end,  resulting  not  only  in  a  general 
disrupting  of  financial  and  business  activities  but  also  in 
unsettling  the  customary  ethical  concepts  which  lie  at  the 
very  basis  of  modern  commercial  life.  Some  cf  these  effects 
were  noted  above  in  the  chapter  on  "The  Standard  for  Deferred 
Payments," 

The  Confederate  States  had  a  disastrous  experience  with  fiat 
currency.  In  view  of  the  grave  monetary  crisis  that  confronts 
the  continental  countries  of  Europe  as  an  aftermath  of  the 
Great  War,  it  will  be  of  interest  to  recall  the  experience  of  our 
own  Confederate  States  during  the  Civil  War.  The  following 
is  the  story  of  one  who  apparently  "enjoyed"  a  first-hand 
experience.' 

The  history  of  the  South  during  the  Civil  War  furnishes  one  of 
the  best  illustrations  on  record  of  the  disastrous  consequences  of 
relying  mainly  upon  the  issue  of  irredeemable  paper  currency  as  a 
means  of  financing  war.  There  were  some  slight  tax  levies,  it  is  true, 
and  some  borrowing  through  the  use  of  bonds,  but  paper  money  was 
looked  to  from  the  first  as  the  chief  fiscal  resource  of  the  government. 
There  was  only  one  difficulty  incident  to  the  process  of  printing 
treasury  notes  enough  to  meet  all  the  exp>enses  of  the  government, 
namely,  the  impossibility  of  having  the  notes  signed  in  the  Treasury 
Department  as  fast  as  they  were  needed.  There  happened,  however, 
to  be  several  thousand  young  ladies  in  Richmond  wilUng  to  accept 
light  and  remunerative  employment  in  their  homes,  and  as  it  was 
really  a  matter  of  small  moment  whose  name  the  notes  bore,  they  were 
given  out  in  sheets  to  these  young  ladies,  who  signed  and  retiuned 
them  for  a  consideration.  I  shall  not  undertake  to  guess  how  many 
Confederate  treasury  notes  were  issued.    Indeed,  I  am  credibly 

'  G.  C.  Eggleston,  A  Rebel's  Recollections,  pp.  78-105. 


94  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

infonned  by  a  gentleman  who  was  high  in  office  in  the  Treasury 
Department,  that  even  the  secretary  himself  did  not  certainly  know. 
The  acts  of  Congress  authorizing  issues  of  currency  were  the  hastily 
formulated  thought  of  a  not  very  wise  body  of  men,  and  my  informant 
tells  me  that  they  were  frequently  susceptible  of  widely  different 
construction  by  different  officials.  However  that  may  be,  it  was 
clearly  out  of  the  power  of  the  government  ever  to  redeem  the  notes, 
and  whatever  may  have  been  the  state  of  affairs  within  the  Treasury, 
nobody  outside  its  precincts  ever  cared  to  muddle  his  head  in  an 
attempt  to  get  at  exact  figures. 

We  knew  only  that  money  was  astonishingly  abundant.  Provi- 
sions fell  short  sometimes,  and  the  supply  of  clothing  was  not  always 
as  large  as  we  should  have  liked,  but  nobody  found  it  difficult  to  get 
money  enough.    It  was  to  be  had  almost  for  the  asking. 

Money  was  so  easily  got,  and  its  value  was  so^utterly  uncertain, 
that  we  were  never  able  to  determine  what  was  a  fair  price  for  any- 
thing. We  fell  into  the  habit  of  paying  whatever  was  asked,  knowing 
that  tomorrow  we  should  have  to  pay  more.  Speculation  became  the 
easiest  and  surest  thing  imaginable.  The  speculator  saw  nc  i.ks  of 
loss.  Every  article  of  merchandise  rose  in  value  every  day,  and  to 
buy  anything  this  week  and  sell  it  next  was  to  make  an  enormous 
profit  quite  as  a  matter  of  course. 

Naturally  enough,  speculation  soon  fell  into  very  bad  repute,  and 
the  epithet  "speculator"  came  to  be  considered  the  most  opprobrious 
in  the  whole  vocabulary  of  invective.  The  feeling  was  imiversal  that 
the  speculators  were  fattening  upon  the  necessities  of  the  country 
and  the  sufferings  of  the  people.  Nearly  all  mercantile  business  was 
regarded  with  suspicion,  and  much  of  it  fell  into  the  hands  of  people 
with  no  reputations  to  lose,  a  fact  which  certainly  did  not  tend  to 
reUeve  the  community  in  the  matter  of  high  prices. 

The  prices  which  obtained  were  almost  fabulous,  and  singularly 
enough  there  seemed  to  be  no  sort  of  ratio  between  the  values  of 
different  articles.  I  bought  coffee  at  forty  dollars  and  tea  at  thirty 
dollars  a  pound  on  the  same  day.  My  dinner  at  a  hotel  cost  me 
twenty  dollars,  while  five  dollars  gained  me  a  seat  in  the  dress  circle 
of  the  theater.  I  paid  one  dollar  the  next  morning  for  a  copy  of  the 
Examiner,  but  I  might  have  got  the  Whig,  Dispatch,  Enquirer,  or 
Sentinel  for  half  that  sum.  For  some  wretched  tallow  candles  I  paid 
ten  dollars  a  pound.  The  utter  absence  of  proportion  between  these 
several  prices  is  apparent,  and  I  know  of  no  way  of  explaining  it 
except  upon  the  theory  that  the  unstable  character  of  the  money 


REGULATION  OF  PAPER  CURRENCY  95 

had  superinduced  a  reckless  disregard  of  all  value  on  the  part  of  both 
buyers  and  sellers.  A  facetious  friend  used  to  say  prices  were  so  high 
that  nobody  could  see  them,  and  that  they  "got  mixed  for  want  of 
supervision."  He  held,  however,  that  the  difference  between  the  old 
and  the  new  order  of  things  was  a  trifling  one.  "Before  the  war," 
he  said,  "I  went  to  market  with  the  money  in  my  pocket,  and  brought 
back  my  pxirchases  in  a  basket;  now  I  take  the  money  in  the  basket, 
and  bring  the  things  home  in  my  pocket." 

In  the  winter  of  1863-64  Congress  became  aware  of  the  fact  that 
prices  were  higher  than  they  should  be  under  a  sound  currency.  If 
Congress  suspected  this  at  any  earlier  date,  there  is  nothing  in  the 
proceedings  of  that  body  to  indicate  it.  Now,  however,  the  news- 
papers were  calling  attention  to  an  unconunonly  ugly  phase  of  the 
matter,  and  reminding  Congress  that  what  the  government  bought 
with  a  currency  depreciated  to  less  than  i  per  cent  of  its  face,  the 
government  must  some  day  pay  for  in  gold  at  par.  The  lawgivers 
took  the  alarm  and  sat  themselves  down  to  devise  a  remedy  for  the 
evil  condition  of  affairs.  With  that  infantile  simplicity  which  char- 
acterized nearly  all  the  doings  and  quite  aU  the  financial  legislation 
of  the  Richmond  Congress,  it  was  decided  that  the  very  best  way  to 
enhance  the  value  of  the  currency  was  to  depreciate  it  stiU  further 
by  a  declaratory  statute,  and  then  to  issue  a  good  deal  more  of  it. 
The  act  set  a  day,  after  which  the  currency  already  in  circulation 
should  be  worth  only  two-thirds  of  its  face,  at  which  rate  it  was  made 
convertible  into  notes  of  the  new  issue,  which  some,  at  least,  of  the 
members  of  Congress  were  innocent  enough  to  believe  would  be 
worth  very  nearly  their  par  value.  This  measure  was  intended,  of 
course,  to  compel  the  funding  of  the  currency,  and  it  had  that  effect 
to  some  extent,  without  doubt.  Much  of  the  old  currency  remained 
in  circulation,  however,  even  after  the  new  notes  were  issued.  For  a 
time  people  calculated  the  discount,  in  passing  and  receiving  the  old 
paper,  but  as  the  new  notes  showed  an  undiminished  tendency  to  still 
further  depreciation,  there  were  people,  not  a  few,  who  spared  them- 
selves the  trouble  of  making  the  distinction. 

The  financial  condition  got  steadily  worse  to  the  end  of  the  war. 
I  beheve  the  highest  price,  relatively,  I  ever  saw  paid,  was  for  a  pair 
of  boots.  A  cavalry  officer,  entering  the  little  country  store,  found 
there  one  pair  of  boots  which  fitted  him.  He  inqtiired  the  price. 
"Two  hundred  dollars,"  said  the  merchant.  A  five  hundred  dollar 
bill  was  offered,  but  the  merchant  having  no  smaller  bills,  could  not 
change  it.    "Never  mind,"  said  the  cavalier,  "I'll  take  the  boots 


96  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

anyhow.    Keep  the  change;    I  never  let  a  little  matter  of  three 
hundred  dollars  stand  in  the  way  of  a  trade." 

Will  the  reader  believe  that  with  gold  at  a  hundred  and  twenty- 
five  for  one,  or  12,400  per  cent  premium;  when  every  day  made  the 
hopelessness  of  the  struggle  more  apparent ;  when  our  last  man  was  in 
the  field;  when  the  resources  of  the  country  were  visibly  at  an  end, 
there  were  financial  theorists  who  honestly  believed  that  by  a  mere 
trick  of  legislation  the  currency  could  be  brought  back  to  par?  I 
heard  some  of  these  people  explain  their  plan  during  a  two  days'  stay 
in  Richmond.  Gold,  they  said,  is  an  inconvenient  currency  always, 
and  nobody  wants  it,  except  as  a  basis.  The  government  has  some 
gold — several  millions,  in  fact — and  if  Congress  will  only  be  bold 
enough  to  declare  the  treasury  notes  redeemable  at  par  in  coin,  we 
shall  have  no  further  difl&culty  with  our  finances.  So  long  as  notes 
are  redeemable  in  gold  at  the  option  of  the  holdei:,.  nobody  wants 
them  redeemed.  Let  the  government  say  to  the  people,  We  will 
redeem  the  currency  whenever  you  wish,  and  nobody  except  a  few 
timid  and  unpatriotic  people  will  care  to  change  their  convenient  for 
an  inconvenient  money.  The  gold  which  the  government  holds  will 
suflice  to  satisfy  these  timid  ones,  and  there  will  be  an  end  of  high 
prices  and  depreciated  currency.  The  government  can  then  issue  as 
much  more  currency  as  circiunstances  may  make  necessary,  and  strong 
in  our  confidence  in  ourselves  we  shall  be  the  richest  people  on  earth: 
we  shall  have  created  the  untold  wealth  which  our  currency  represents. 

When  the  full  story  of  the  present  paper  currencies  of 
Central  and  Eastern  Europe  shall  be  told,  we  shall  doubtless 
find  that  it  presents  a  striking  parallel  to  this  Confederate 
monetary  history.  Indeed,  the  evidence  already  available 
indicates  price  increases  quite  as  phenomenal.  With  the  end 
of  the  Civil  War  and  the  collapse  of  the  Confederate  govern- 
ment, the  Confederate  currency  became  automatically  worth- 
less. The  final  outcome  of  the  present  European  inflation 
will  not  be  disclosed  for  many  years. 

n.    ARGUMENTS  FOR  AND  AGAINST  FIAT 
PAPER  CURRENCY 
The  following  quotations,  taken  from  various  addresses 
and  "programs,"  will  serve  to  reveal  the  nature  of  the  prevalent 
arguments  in  favor  of  irredeemable  pap)er  currency. 


REGULATION  OF  PAPER  CURRENCY  97 

1.  We  (speaking  for  the  Farmers'  Alliance  in  the  nineties)  believe 
in  the  people  making  their  own  money;  we  believe  in  the  government, 
which  is  simply  the  agent  of  the  people,  issuing  their  money  directly 
to  them  without  going  around  Robin  Hood's  barn  to  find  them 
(that  is,  without  the  intermediation  of  banks). 

2.  If  the  people  had  twice  as  much  currency  in  their  pockets  as 
now,  their  prosperity  would  be  greatly  increased. 

3.  I  am  in  favor  of  more  currency.  We  haven't  enough  currency 
per  capita  to  do  the  business  of  the  coimtry.     (Written  in  1894.) 

4.  I  propose  that  the  government,  only,  shall  issue  money  for  the 
public  use.  In  order  to  do  this,  I  would  have  it  issue  immediately 
500,000,000  new  treasury  notes  of  the  denomination  of  one  dollar 
each.  So  much  of  this  amount  as  was  necessary  the  government 
should  loan  to  the  people;  10  per  cent  of  each  loan  to  be  paid  back 
each  year;  q  per  cent  to  be  applied  to  the  extinction  of  the  principal; 
I  per  cent  covering  the  interest.  In  that  way  it  would  be  possible 
to  redeem  every  mortgaged  farm  in  the  land  within  fifteen  years. 

5.  Banks  should  not  be  allowed  to  issue  notes.  These  should  be 
printed  and  put  out  by  the  government.  The  tariff  should  be  reduced 
till  there  is  a  deficit  in  the  Treasury,  and  then  greenbacks  should  be 
printed  and  issued  to  pay  all  claimants.  These  should  not  be  redeem- 
able in  metal  money.  Each  bill  should  bear  the  legend,  "One  dollar, 
receivable  for  all  dues  and  debts."  This  would  make  it  receivable 
for  aU  taxes  and  import  duties  and  a  legal  tender.  This  would  keep 
it  perpetually  at  par. 

The  argument  against  irredeemable  paper  currency  was 
trenchently  stated  as  long  ago  as  the  American  Revolution 
by  John  Witherspoon,  in  the  following  words: 

The  irredeemable  paper  money  such  as  was  issued  by  the  Conti- 
nental Congress  and  the  various  state  legislatures  during  the  Revolu- 
tion, that  is,  paper  bills  stating  that  the  person  holding  them  is  entitled 
to  receive  a  certain  sum  specified  in  them,  is  not,  properly  speaking, 
money  at  all.  It  is  barely  a  sign  without  being  a  pledge  or  standard 
of  value,  and  therefore  is  essentially  defective  as  a  medium  of  uni- 
versal commerce.  To  arm  such  bills  with  the  authority  of  the  state, 
and  make  them  a  legal  tender  in  all  payments,  is  an  absurdity  so 
great  that  it  is  not  easy  to  speak  with  propriety  upon  it.  It  has  been 
found,  by  the  experience  of  ages,  that  money  must  have  a  standard 
value,  and  if  any  prince  or  state  debase  the  metal  below  the  standard, 
it  is  utterly  impossible  to  make  it  succeed.    How  can  it  be  possible 


98  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

to  make  that  succeed  which  has  no  value  at  all  ?  In  all  such  instanues 
there  may  be  great  injuries  done  to  particular  persons  by  wiping  off 
debts;  but  to  give  such  money  general  currency  is  wholly  impossible. 
The  measure  carries  absurdity  on  its  very  face.  Why  wiU  you  make 
a  law  to  oblige  men  to  take  money  when  it  is  offered  them  ?  Are  there 
any  who  refuse  it  when  it  is  good  ?  If  it  is  necessary  to  force  them, 
does  this  not  demonstrate  that  it  is  not  good  ?  We  have  seen,  indeed , 
this  system  produce  a  most  ludicrous  inversion  of  the  nature  of 
things.  For  two  or  three  years  we  constantly  saw  and  were  informed 
of  creditors  running  away  from  their  debtors  and  the  debtors  pursuing 
them  in  triumph,  and  paying  them  without  mercy.' 

Paper  currency  would  not  depreciate  if  the  supply  were  controlled. 
Many  economists  insist  that,  if  properly  controlled,  irredeemable 
paper  will  not  depreciate  in  value.    For  example,  Ricardo  says: 

By  limiting  the  quantity  of  money  it  can  be  raised  to  any  conceiv- 
able value.  It  is  on  this  principle  that  paper  money  circulates;  the 
whole  charge  for  paper  money  may  be  considered  as  seignorage. 
Though  it  has  no  intrinsic  value,  yet  by  limiting  its  quantity,  its 
value  in  exchange  is  as  great  as  an  equal  denomination  of  coin  or  of 
bullion  in  that  coin.  There  is  no  point  more  important  in  issuing 
paper  money  than  to  be  fully  impressed  with  the  effects  which  follow 
from  the  principle  of  limitation  of  quantity.  It  is  not  necessary 
that  paper  money  should  be  payable  in  specie  to  secure  its  value;  it 
is  only  necessary  that  its  quantity  should  be  regulated  according  to 
the  value  of  the  metal  which  is  declared  to  be  the  standard. 

Experience,  however,  shows  that  neither  a  state  nor  a  bank  ever 
has  had  the  unrestricted  power  of  issuing  paper  money,  without 
abusing  that  power;  in  all  states,  therefore,  the  issue  of  paper  money 
ought  to  be  under  some  theck  and  control;  and  none  seems  so  proper 
for  that  purpose  as  that  of  subjecting  the  issuers  of  paper  money  to 
the  obligation  of  paying  their  notes,  either  in  gold  coin  or  in  bullion." 

III.  METHODS  OF  REGULATING  PAPER  CURRENCY 

The  following  methods  have  been  used  in  regulating  the 
issues  of  government  paper  currency: 

I.  Full  specie  reserve  method. — By  this  method  the  issuing 
government  retains  in  its  coffers  metallic  money  equal  in  amount 

'  Adapted  from  Works,  IV,  222-23.       '  Principles  of  Political  Economy. 


REGULATION  OF  PAPER  CURRENCY  99 

to  the  paper  issued.    The  paper  is  thus  a  true  representative 
currency,  serving  merely  in  lieu  of  so  much  specie. 

2.  Percentage  specie  reserve  method. — With  this  method  a 
specie  reserve  equal  to  a  certain  fixed  percentage  of  the 
paper  must  be  held  by  the  issuing  government.  The  amount 
of  paper  may  be  changed  with  changes  in  the  amount  of 
reserve. 

3.  Minimum  specie  reserve  method. — A  certain  fixed 
minimum  quantity  of  specie  is  held  as  reserve,  and  the  paper 
outstanding  against  this  may  or  may  not  be  increased  or 
decreased. 

4.  The  uncovered  issue  method. — A  certain  fixed  amount  of 
paper  may  be  issued,  secured  by  bonds,  etc.,  and  beyond  this 
amount  any  quantity  may  be  issued  if  backed  by  a  full  specie 
reserve. 

5.  The  elastic  uncovered  issue  method. — This  method  differs 
from  the  above  only  in  that  the  uncovered  issue  may  be  extended 
in  time  of  emergency. 

6.  Property  reserve  method. — ^Land  or  other  real  estate,  or 
personalty  such  as  bonds,  stocks,  etc.,  may  be  used  as  security 
for  government  paper  currency. 

7.  Revenue  payments  method. — A  free  issue  of  paper  money 
which  relies  on  its  acceptability  for  taxes  in  lieu  of  coin  to  keep 
up  its  value. 

8.  The  deferred  convertibility  method. — Notes  may  be  issued 
promising  to  pay  metallic  money  at  some  future  date,  either 
definitely  fixed,  or  dependent  upon  political  or  other  contingent 
events. 

9.  Fiat  method. — ^The  government  may  give  freely  issued 
paper  full  legal-tender  power  and  command  its  acceptance  in 
payment  of  all  obligations.     It  is  irredeemable. 

10.  Limited  issue  method. — A  fiat  issue  may  be  definitely 
restricted  in  amount  in  order  that  an  active  demand  may  pre- 
vent depreciation. 

11.  F or ce-of -habit  method. — An  issue  once  redeemable  may 
circulate  by  force  of  custom  after  the  government  has  been 
absolved  from  the  obligation  of  redemption. 


lOO         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Of  these  various  methods  of  maintaining  the  value  of  paper 
currency  the  first  five  are  the  ones  now  most  commonly  used 
in  the  important  commercial  countries  of  the  world.  Of  those 
which  do  not  involve  a  full  specie  reserve,  the  second,  third, 
and  fourth  are  the  most  frequently  employed  at  the  present 
time.  The  various  methods  used  in  the  United  States  at  the 
present  will  be  shown  in  the  section  which  follows.  It  remains 
to  state  that  while  this  chapter  is  devoted  only  to  government 
paper  currency,  some  of  the  methods  of  regulation  here  out- 
lined are  worked  out  through  banking  institutions. 

IV.    FORMS  OF  GOVERNMENT  PAPER  CURRENCY 
IN  THE  UNITED  STATES 

The  forms  of  government  paper  currency  in  the  United 
States  at  the  present  time  and  the  main  facts  as  to  their 
nature  and  history  are  as  follows: 

a)  Gold  certificates. — Gold  certificate?  are  mere  claim  checks 
to  like  quantities  of  gold  held  in  the  Treasury.  These  certifi- 
cates date  back  to  the  Civil  War  period.  The  inconvenience 
of  gold  for  everyday  exchange  transactions  led  to  an  authoriza- 
tion by  the  Secretary  of  the  Treasury  to  receive  gold  in  sums 
of  not  less  than  twenty  dollars  and  to  issue  certificates  in  its 
place.  None  may  be  issued  in  a  denomination  of  less  than 
ten  dollars;  and  at  least  one-fourth  of  the  certificates  shall 
be  in  denominations  of  fifty  dollars  or  less.  They  are  designed 
to  meet  the  needs  of  our  large  monetary  transactions. 

h)  Silver  certificates. — The  use  of  silver  certificates,  which 
are  claim  checks  to  silver  deposited  in  the  Treasury,  was  author- 
ized by  the  Bland-Allison  Act  of  1878.  Silver  currency  was 
redundant  and  the  purpose  of  authorizing  the  issue  of  certifi- 
cates was  to  encourage  the  circulation  of  silver,  in  substitute 
form.  The  Secretary  of  the  Treasury  is  required  to  accept 
any  quantity  of  silver,  in  sums  not  less  than  ten  dollars,  and 
to  issue  as  substitutes  therefor  silver  certificates  in  denomi- 
nations of  ten  dollars  and  less.  From  1890  until  our  entrance 
into  the  Great  War  the  volume  of  silver  certificates  remg,ined 


REGULATION  OF  PAPER  CURRENCY  lOl 

practically  unchanged  except  in  so  far  as  they  were  increased  by 
the  process  of  retiring  the  Treasury  notes  of  1890  (see  c),  below). 
The  Pittman  Act  of  19 18,  however,  has  led  to  a  substantial, 
though  temporary,  reduction  in  the  volume  of  silver  certificates. 
This  act,  which  grew  out  of  the  exigencies  of  war  finance,  was 
designed  to  release  American  silver  for  export  to  the  Orient  in 
payment  of  trade  balances.  It  authorized  the  Secretary  of 
the  Treasury  to  convert  into  silver  dollars  the  bullion  held 
in  reserve  in  the  Treasury  against  outstanding  silver  certifi- 
cates; and  as  these  silver  dollars  were  exported  a  proportional 
volume  of  silver  certificates  was  retired.  The  act  provided  for 
the  eventual  replacing  of  the  silver  thus  released  by  requiring 
the  Treasury  ultimately  to  repurchase  silver  at  a  price  of  $1 .00 
an  ounce,  the  total  amount  finally  involved  being  207,000,000 
ounces.  Under  the  terms  of  the  loss  the  Treasurer  is  required 
to  purchase  silver  bullion  (American  product  only)  whenever 
its  price  is  $1 .00  an  ounce  or  less;  but  whenever  the  price  of 
bullion  is  above  $1.00  an  ounce  none  is  purchased.  The 
process  of  repurchase  may  therefore  extend  over  many  years; 
and  it  is  possible  that  it  will  never  be  entirely  consummated. 
Some  silver  was,  in  fact,  repurchased  in  the  summer  of  1920. 

c)  Treasury  notes  of  i8go. — These  government  notes  were 
issued  as  a  means  of  purchasing  silver  bullion  under  the  terms 
of  the  Sherman  Silver  Purchase  Act  of  1890,  repealed  in  1893. 
In  1893  there  were  $153,931,002  outstanding,  but  they  are 
now  canceled  as  fast  as  received  at  the  Treasury,  and  are 
therefore  gradually  disappearing  from  circulation.  There 
were  outstanding  on  February  i,  1920,  only  $1,695,736. 
When  retired,  their  place  is  taken  directly  by  silver  dollars 
coined  from  the  bullion  originally  purchased  with  the  notes. 
Indirectly  their  place  is  filled  in  the  channels  of  circulation 
by  a  silver  certificate  issued  as  representative  of  the  silver 
dollar. 

d)  United  States  Notes. — United  States  Notes,  or  greenbacks, 
were  first  issued  during  the  Civil  War  to  meet  the  expenses  of  the 
government.  Since  1878  there  have  been  outstanding  $346,- 
681,016.    They  are  backed  by  a  cash  reserve  of  $150,000,000, 


102         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

held  as  a  special  funds  in  the  Treasury.  The  amount  of  these 
notes  never  increases  or  decreases,  since  the  law  provides  that 
any  notes  redeemed  in  cash  at  the  Treasury  shall  be  promptly 
reissued.  They  have  usually  been  issued  in  five-  and  ten-doUai 
demoninations;  but  because  of  the  dearth  of  small  bills  that 
was  occasioned  by  the  great  increase  in  prices  during  the  war, 
and  hence  in  the  quantity  of  money  required  to  carry  on  our 
trade  and  business  operations,  they  are  now  also  issued  in  one- 
and  two-dollar  denominations. 


V.  REDEMPTION  OF  UNITED  STATES 
PAPER  CURRENCY 

The  provisions  governing  the  redemption  in  specie  of  the 
various  forms  of  government  paper  currency  in  the  United 
States  at  the  present  time  are  as  follows: 

United  States  Notes  are  redeemable  in  United  States  gold 
coin  in  any  amount  by  the  Treasurer  and  all  the  assistant 
treasurers  of  the  United  States. 

Treasury  notes  of  i8go  are  redeemable  in  United  States 
gold  coin  in  any  amount  by  the  Treasurer  and  all  the  assistant 
treasurers  of  the  United  States. 

Gold  certificates,  being  receipts  for  gold  coin,  are  redeemable 
in  such  coin  by  the  Treasurer  and  all  assistant  treasurers  of 
the  United  States. 

Silver  certificates  are  receipts  for  standard  silver  dollars 
deposited,  and  are  redeemable  in  such  dollars  only. 


VI.    LEGAL  TENDER  PROVISIONS  OF  UNITED 
STATES  PAPER  CURRENCY 

The  legal  tender  provisions  applicable  to  the  various  forms 
of  United  States  paper  currency  at  the  present  time  reflect  the 
exigencies  of  our  financial  history.  Some  of  the  "exceptions" 
which  were  important  at  one  time  or  another  are  now  of  no 
significance. 


REGULATION  OF  PAPER  CtJRRENCY 


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I04         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Treasury  notes  of  i8qo  are  legal  tender  for  all  debts,  public 
and  private,  except  where  otherwise  expressly  stipulated  in  the 
contract.  They  are  thus  on  exactly  the  same  basis  as  the 
standard  silver  dollars. 

United  States  Notes,  or  greenbacks  are  legal  tender  for  all 
debts,  public  and  private,  except  duties  on  imports  and  interest 
on  the  public  debt.  These  exceptions  were  an  outgrowth 
of  Civil  War  financial  exigencies.  Since  the  greenbacks  were 
depreciated  in  value,  to  have  made  them  legal  tender  for  inter- 
est on  government  bonds  would  have  made  it  impossible  to  sell 
bonds  except  at  a  tremendous  discount.  And  since  the  govern- 
ment elected  always  to  pay  interest  on  government  bonds  in 
specie,  it  was  necessary  to  insist  that  the  customs  duties,  the 
principal  source  of  revenue,  should  be  paid  in  specie  rather 
than  in  depreciated  greenbacks.  Upon  resumption  of  specie 
payments  on  January  i,  1879,  the  United  States  Notes,  then 
at  a  parity  with  gold,  were,  by  Treasury  order,  made  accept- 
able in  payment  of  duties  on  imports.  The  wording  of  the 
original  law,  however,  has  not  been  changed.  Since  they  are 
now  at  a  parity  with  gold,  it  is  obvious  that  the  restriction 
on  their  use  in  the  payment  of  interest  on  the  public  debt  is 
also  a  dead  letter. 

Gold  and  silver  certificates  were  not  given  a  specific  grant  of 
power  in  the  settlement  of  private  debts  until  1920.  But,  since 
they  were  always  receivable  for  public  dues  and  were  redeem- 
able in  gold  and  silver  coin  respectively,  no  one  had  any 
occasion  to  refuse  to  accept  them;  indeed,  few  people  ever 
realized  that  they  were  not  legal  tender.  The  belated  grant  of 
legal  tender  power  is  therefore  only  an  act  of  supererogation. 


QUESTIONS  FOR  DISCUSSION 

1.  What  are  the  chief  arguments  for:  (o)  representative  paper 
currency?  {h)  fiduciary  convertible  paper?  (c)  fiat  or  irre- 
deemable paper?    Do  you  think  these  arguments  are  sound? 

2.  Over  which  kind  of  paper  money  do  you  think  the  greatest 
controversy  has  been  waged  ? 


REGULATION  OF  PAPER  CURRENCY  105 

3 1  Is  there  a  genuine  saving  of  interest  from  the  use  of  convertible 
fiduciary  paper  ? 

4.  "An  issue  of  paper  currency  by  a  government  is  a  forced  loan." 
Explain. 

5.  When  irredeemable  paper  is  given  legal  tender  power  and  the 
paper  is  not  at  a  parity  with  the  standard  metallic  currency,  will 
prices  be  made  in  paper  or  in  the  standard  metal?    Why? 

6.  What  would  be  the  effect  of  an  irredeemable  paper  stand- 
ard upon:  (a)  time  contracts?  (6)  business  risks?  (c)  business 
activity  ? 

7.  Can  paper  money  have  any  value  if  it  is  not  redeemable,  either 
immediately  or  ultimately  ? 

8.  Is  there  any  means  by  which  it  can  be  inconvertible  and  yet  be 
prevented  from  depreciating  ? 

Q.  "Value  is  dependent  upon  cost  of  production,  and  the  cost  of 
producing  paper  money  is  virtually  negligible;  therefore  the 
value  of  paper  money  must  be  virtually  negligible."     Criticize. 

10.  "Paper  money  is  all  right  in  theory;  but  it  will  not  work  in 
practice."    Discus?. 

11.  "The  lesson  of  America's  fight  against  paper  currency  should 
never  be  lost  to  the  instructors  of  youth  or  the  statesmen  of  this 
country.  The  only  way  to  make  inflationism  truly  dangerous 
is  to  be  afraid  of  it.  Once  the  calm,  unfaltering  eye  of  courageous 
reason  is  fixed  on  the  savage  thing  that  would  rend  the  nation, 
it  shrinks  back  o'ermastered  to  its  lair."  This  was  written  in 
1892.    Do  you  agree  ? 

12.  As  a  practical  matter  is  it  possible  to  avoid  the  use  of  irredeemable 
currency  in  time  of  war  ? 

13.  Of  the  various  methods  employed  for  maintaining  the  value  of 
paper  money  without  specie  redemption,  which  do  you  regard 
as  most  eflBicient  ? 

14.  Of  the  various  methods  of  maintaining  the  convertibility  of  paper 
money,  which  do  you  think  preferable  ? 

15.  Which  of  these  methods  of  regulating  paper  currency  are  now 
used  in  the  United  States  ? 

16.  Upon  what  does  the  value  of  the  silver  certificate  depend: 
(a)  immediately?  (b)  ultimately? 

17.  Look  up  in  the  financial  press  the  present  price  of  silver  bullion 
and  tell  whether  the  Treasurer  is  now  purchasing  silver  vmder 
the  terms  of  the  Pittman  act. 


io6         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

1 8.  Upon  what  does  the  value  of  the  gold  certificate  depend? 

19.  What  percentage  of  trust  or  credit  is  there  in  the  United  States 
Notes  ? 

20.  How  is  it  possible  to  redeem  $346,681,016  of  greenbacks  when 
the  fund  available  for  the  purpose  is  only  $150,000,000? 

21.  What  other  forms  of  oxir  currency,  besides  the  United  States 
Notes,  are  based  in  part  on  faith  ? 

22.  Can  you  lay  down  any  general  rule  as  to  the  proportion  the 
standard  money  should  bear  to  the  entire  monetary  stock  of  a 
country  ? 

REFERENCES  FOR  FURTHER  READING 

Holdsworth,  John  Thorn:  Money  and  Banking,  chap.  iv. 
Moulton,  Harold  G. :  Principles  of  Money  and  Banking,  chap.  v. 
Noyes,  Alexander  D.:   Forty  Years  of  American  Finance. 
Phillips,  Chester  A.:   Readings  in  Money  and  Banking,  chap.  v. 
White,  Horace:  Money  and  Banking,  chaps,  i-iv. 


CHAPTER  Vm 

THE  FOREIGN  EXCHANGES 

In  this  chapter  we  axe  to  consider  the  financial  mechanism 
known  as  the  foreign  exchanges,  by  means  of  which  the  great 
majority  of  international  trading  and  financial  obligations 
are  settled  without  requiring  monetary  payments.  The 
"exchanges"  have  always  been  a  sealed  mystery  to  the  rank 
and  file  of  even  well-informed  people  for  the  reason  that  an 
understanding  of  the  mechanism  involved  requires  a  certain 
amount  of  simple  technical  information,  which  the  "average 
citizen"  is  never  ^\'illing  to  acquire.  Of  late,  however,  because 
of  the  great  depreciation  of  foreign  currencies  that  has  resulted 
from  the  financial  and  trade  exigencies  of  the  Great  War  and 
the  potential  effects  of  this  upon  the  American  industrial 
situation,  the  subject  has  attracted  unusual  attention,  and 
even  the  man  in  the  street  is  now  vaguely  conscious  that 
foreign  exchange  is,  somehow  or  other,  a  subject  of  no  little 
practical  significance. 

I.  THE  NATURE  OF  THE  PROBLEM 

Foreign  exchange  is  concerned  with  the  settlement  of  inter- 
national financial  obligations.  Whenever  an  American  travels 
in  Europe  he  requires  funds  with  which  to  meet  the  expenses 
incident  to  travel;  whenever  a  merchant  in  the  United  States 
buys  goods  from  Europe,  he  needs  a  means  of  paying  his 
debt  to  the  foreign  seller;  whenever  a  European  wishes  to 
buy  American  securities,  some  means  of  payment  must  be 
found;  in  a  word,  whenever  any  international  transaction 
takes  place,  a  settlement  must  be  made.  The  nature  of 
the  problem  may  be  most  clearly  revealed  by  a  statement  of 
the  principal  sources  of  international  obligations  that  have 
normally  existed  between  the  United  States  and  Great  Britain. 

107 


loS         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

a)  Transactions  tending  to  cause  an  outflow  of  funds  from 
the  United  States: 

1.  American  imports  of  British  goods 

2.  American  premiums  on  British  insurance 

3.  Interest  payments  on  British  investments 

4.  American  bank  loans  to  British  banks 

5.  American  payments  of  freight  bills  to  British  ship  owners 

6.  Expenditures  of  American  tourists  abroad 

b)  Transactions  tending  to  cause  an  inflow  of  funds  to  the 
United  States: 

1.  Exports  of  goods  to  Great  Britain 

2.  Payment  of  British  insurance  policies  to  Americans 

3.  British  investments  in  American  securities 

4.  British  bank  loans  to  American  banks 

Now  it  is  obvious  that  if  every  individual  transaction  involv- 
ing payments  by  Americans  abroad  were  settled  in  actual 
money,  and  if  every  transaction  involving  payments  by  Great 
Britain  to  the  United  States  were  met  by  a  shipment  of  specie,' 
a  very  considerable  portion  of  our  monetary  resources  would  be 
constantly  in  transit  between  the  two  coimtries,  for  the  volume 
of  international  settlements  effected  in  the  course  of  each  year 
runs  into  hundreds  of  milhons  of  dollars.  Such  shipments  of 
actual  money  would  obviously  be  subject  to  the  risks  of  ocean 
transportation,  and  to  substantial  costs  through  loss  of  inter- 
est on  the  money  while  in  transit  and  in  cormection  with  the 
packing  and  expressing  of  the  currency.  Clearly  a  mechan- 
ism that  would  make  possible  a  reciprocal  cancellation  of 
the  greater  part  of  these  obligations  would  be  of  very  great 
economic  advantage.  In  brief,  it  is  the  function  of  the  foreign 
exchanges  to  cancel  all  except  the  net  balance  of  indebtedness, 
that  is,  the  difference  between  the  total  of  transactions  involv- 
ing an  outward  flow,  and  the  total  of  transactions  involving  an 
inward  flow,  of  funds.  This  balance  is  met  by  currency  ship- 
ments. 

'  Specie,  alone,  is  acceptable  in  international  monetary  settlements 
and  it  is  accepted  by  weight  and  fineness  only. 


THE   FOREIGN  EXCHANGES  109 

II.    THE  EXCHANGE  MECHANISM 

The  means  by  which  international  payments  are  effected 
largely  without  the  shipment  of  specie  is  by  sending  bills  of 
exchange  abroad  in  lieu  of  actual  cash.  In  order  to  make  the 
process  clear,  it  will  be  necessary  to  understand,  first,  precisely 
what  is  meant  by  the  parity  of  exchange,  "gold  points,"  and 
bills  of  exchange. 

Exchange  between  United  States  and  England  is  said  to  be  at 
par  when  a  sterling  bill  is  M'orth  4.866  in  New  York.  What 
does  par  or  parity  of  exchange  mean,  and  how  is  this  quotation, 
4.866,  derived?  Parity  of  exchange  is  nothing  but  a  simple 
statement  of  the  relative  value  of  American  and  British  coins. 
The  gold  in  the  British  monetary  unit,  the  pound  sterling, 
is  worth  4.866  times  as  much  as  the  gold  in  the  American 
monetary  unit,  the  dollar.  The  par  exchange  rate  thus  depends 
upon  the  varying  gold  content  of  the  monetary  units  of  the 
different  countries. 

The  par  of  exchange  between  the  United  States  and  France 
is  5 .  18,  the  American  dollar  being  5.18  times  as  valuable  as  the 
French  unit,  the  franc.  The  franc  is  thus  worth  in  terms  of 
our  money  a  little  over  19  cents.  France,  Belgium,  Italy, 
Switzerland,  and  Greece  belong  to  the  Latin  Monetary  Union, 
with  monetary  units  of  equal  weight  and  fineness,  though  of 
different  names;  hence  the  par  of  exchange  between  the  United 
States  and  all  of  these  countries  is  5.18.  Parity  of  exchange 
with  Germany  is  23.8,  the  mark  being  worth  23.8  cents.  It 
is  of  note  that  in  quoting  French  exchange  it  is  customary  to 
state  the  number  of  francs  in  a  dollar,  while  in  comparing 
American  and  British  coins  we  speak  of  the  number  of  dollars 
that  it  takes  to  equal  one  pound  sterHng  (4.866).  The  French 
quotations  are  thus  stated  inversely. 

The  money  of  each  of  the  various  countries  has  its  par- 
ticular parity  as  compared  with  United  States  coins,  and  in 
turn  the  pound  sterling,  franc,  etc.,  each  has  its  parity  with  the 
coins  of  all  the  other  countries.  It  is  unnecessary  for  our 
present  purpose  to  enter  into  a  detailed  discussion  of  all  these 
quotations,  for  they  all  involve  a  common  principle. 


no         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  use  of  bills  of  exchange  reduces  currency  shipments. 
The  function  of  bills  of  exchange  may  best  be  revealed  by  the 
use  of  some  concrete  illustrations.  Let  us  assume  that  Mr.  A 
in  New  York  has  sold  £i,ooo  worth  of  goods  to  Mr.  X  in  London, 
and  that  at  the  same  time  Mr.  B  in  New  York  has  purchased 
£i,ooo  worth  of  goods  from  Mr.  Y  in  London.  It  is  apparent 
that  if  it  could  be  arranged  so  that  B  could  pay  A  and  X  could 
pay  Y,  it  would  be  unnecessary  to  ship  any  currency  in  order 
to  settle  these  obligations.  If  A  were  to  draw  an  order  (or 
bill  of  exchange)  on  X  in  London  ordering  X  to  pay  Y  £i,ooo 
and  then  could  sell  the  bill  to  B,  he  would  receive  his  money 
from  B ;  then  if  B  sent  this  bill  over  to  Y  and  Y  presented  it  to 
X,  who  paid  it,  both  obligations  would  have  been  settled  with- 
out the  use  of  any  currency. 

But  in  practice  there  are  usually  two  difficulties  which  pre- 
vent this  simple  solution  of  the  problem.  In  the  first  place,  A  is 
not  usually  acquainted  with  B,  and  X  is  not  usually  acquainted 
with  Y.  Secondly,  the  amounts  involved  in  the  two  transactions 
are  not  usually  identical.  Accordingly,  dealers  in  foreign  ex- 
change (banks  and  brokers)  are  required  as  financial  intermedi- 
aries. When  A  draws  his  bill  of  exchange  for  £i,ooo  of  exchange 
on  the  London  buyer  of  his  goods,  he  takes  it  to  a  foreign-exchange 
banker,  who  pays  him,  when  exchange  is  at  par,  $4,866.  The 
banker  then  sends  the  bill  to  a  correspondent  bank  in  London, 
which  presents  the  bill  to  X  for  payment.  The  payment  is 
next  deposited  with  the  London  bank  to  the  credit  of  the  New 
York  bank.  Now  when  B  wants  to  buy  a  bill  of  exchange  he 
goes  to  the  foreign  exchange  banker  and  the  banker  sells  him  a 
draft  drawn  against  this  London  bank  account — a  draft  for 
£1,000,  or  for  whatever  amount  the  buyer  may  desire.'  B  then 
sends  the  draft  to  Y  in  London  and  Y  presents  it  to  the  bank 
against  which  it  is  drawn  and  receives  his  payment.  The  New 
York  banker  thus  acts  as  an  intermediary  between  A  and 
B,  serving  in  effect  to  bring  them  together,  and  serving  also 
to  make  "change,"  that  is,  to  break  up  bills  of  exchange  into 
whatever  denominations  are  required. 

'  See  p.  167  for  a  sample  of  one  of  these  bills. 


THE  FOREIGN  EXCHANGES  III 

Sometimes  these  bills  are  drawn  directly  by  the  exporters 
against  foreign  banks  with  whom  the  foreign  importer  has  made 
arrangements  for  the  purpose.  They  are  sometimes  drawn 
payable  at  "sight,"  that  is,  when  presented,  and  sometimes 
they  run  for  thirty,  sixty,  or  ninety  days,  etc.  The  drafts  may 
have  attached  to  them  documents  in  the  form  of  bills  of  lading 
and  other  shipping  receipts,  or  they  may  be  what  are  known  as 
"clean  bills,"  unaccompanied  by  any  documentary  evidence. 
There  are  many  angles  to  the  problem,  giving  rise  to  many 
different  types  of  bills  involving  different  methods  of  payment; 
but  the  foregoing  simple  illustration  will  suffice  to  reveal  the 
essential  principles  in  all  cases. 

It  remains  to  be  noted  that  bills  of  exchange  are  not  always 
drawn  by  American  banks  or  American  exporters  against 
foreign  banks,  and  sold  to  American  importers  who  have 
remittances  to  make.  The  process  may  be  reversed — the 
method  actually  employed  in  any  given  case  being  a  matter  of 
agreement  between  the  parties  to  the  transaction.* 

The  price  of  exchange  is  determined  by  the  demand  and  supply 
of  bills.  What  now  determines  the  price  at  which  a  bill  of 
exchange  can  be  bought  or  sold  in  the  New  York  market? 
In  the  illustration  above  we  assumed  that  exchange  was  at 
par.  In  fact,  it  is  sometimes  above  and  sometimes  below  par. 
The  price  of  a  bill  of  exchange  is,  like  the  price  of  wheat  or 
any  other  commodity,  a  reflection  of  the  relative  demand  for, 
and  supply  of,  bills  in  the  market  at  the  moment.  If  at  any 
given  time  £1,000,000  worth  of  sterling  bills  were  offered  for 
sale  in  New  York  and  £1,000,000  worth  were  demanded,  the 
price  would  be  at  par,  that  is,  at  4 .  866.  But  if  only  £1,000,000 
worth  of  bills  were  offered  in  the  market  for  sale,  and  £1,200,000 
worth  were  demanded,  the  price  would  be  bid  up  above  4.866 
by  those  who  desired  the  bills  as  a  means  of  meeting  their 
obligations  abroad.  On  the  contrary,  if  only  £800,000  were 
demanded,  the  sellers  would  have  to  make  concessions  in  order 
to  dispose  of  their  bills. 

'  For  a  more  detailed  discussion  see  chap.  xix. 


TI2         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  maximum  extent  to  which  the  price  of  exchange  can 
be  bid  up  or  forced  down,  as  the  case  may  be,  is  determined  by 
the  costs  involved  in  shipping  the  actual  specie.  I  should  be 
willing  to  pay  $4,866  for  a  bill  of  exchange  with  which  to  settle 
a  £1,000  obligation,  because  that  would  be  cheaper  than  shipping 
the  ciurency.  I  should  be  willing  to  pay  as  high  as  $4,885. 
under  normal  conditions,  for  such  a  bill;  but  I  should  not  be 
willing  to  pay  more  than  that,  because  it  would  then  be 
cheaper  for  me  to  ship  the  actual  specie  instead.  On  the  other 
hand,  I  should  be  willing,  if  necessary,  to  sell  a  £1,000  bill  of 
exchange  for  $4,845;  but  not  for  less,  since  it  would  then  be 
cheaper  for  me  to  pay  the  expense  of  importing  the  actual  cur- 
rency. These  points,  4.885  and  4.845,  are  known  as  gold- 
exporting  and  -importing  points. 

The  supply  of  and  demand  for  bills  of  exchange  in  the 
New  York  and  London  exchange  market  depend  at  any  time 
not  merely  upon  the  relative  volume  of  exports  and  imports. 
They  depend  upon  all  of  the  international  operations  outUned 
above  (p.  108).  Whatever  the  occasion  for  remittances  of 
funds  to  Great  Britain,  bills  of  exchange  are  demanded  in  the 
market,  and  whatever  the  occasion  for  payments  to  the  United 
States,  bills  of  exchange  are  drawn  and  oflFered  for  sale.  For 
instance,  if  an  individual  is  contemplating  a  trip  abroad,  he 
places,  say,  $1,000  with  his  bank,  with  an  express  company,  or 
with  one  of  the  tourist  concerns,  and  asks  for  letters  of  credit  or 
travelers'  checks.  It  is  then  necessary  for  the  bank  where  the 
funds  have  been  deposited  to  transmit  means  of  payment  to  the 
other  side,  and  this  it  does  by  buying  a  bill  of  exchange  which  it 
sends  to  a  correspondent  bank  in  Europe,  where  it  is  credited 
to  the  account  of  the  American  bank  and  made  available  for  the 
payment  of  checks  when  properly  signed  by  the  authorized  party. 

Finance  bills  serve  as  a  buffer  against  currency  movements. 
Finance  bills,  which  are  to  be  considered  in  connection  with  the 
borrowing  and  lending  of  bank  balances  (see  outline  p.  108) 
also  play  an  important  part  in  maintaining  the  balance  of 
payments  and  in  minimizing  shipments  of  specie.  International 
bankers  have  frequent  occasion  to  increase  or  decrease  their 


THE  FOREIGN  EXCHANGES  113 

balances  with  correspondent  banks  abroad;  and  they  buy 
or  sell  finance,  as  distinguished  from  trade,  bills  of  exchange 
as  a  means  of  accomplishing  the  desired  result.  Among  the 
factors  making  it  desirable  for  a  New  York  bank  to  increase  its 
balance  abroad  would  be  higher  interest  rates  in  London  than 
in  New  York. 

As  a  means  of  minimizing  the  volume  of  currency  ship- 
ments, international  bankers  also  usually  establish  foreign 
credits  by  borrowing  when  there  is  reason  to  believe  that  the 
balance  will  soon  turn  the  other  way.  If  international  obhga- 
tions  are  considerably  out  of  balance,  however,  it  is  impossible 
for  the  bankers  to  stand  in  the  breach  for  long;  exchange  soon 
moves  to  the  gold-exporting  or  -importing  point,  as  the  case 
may  be,  and  gold  flows  out  or  in  to  restore  the  equilibrium. 

Roundahoui  operations  minimize  the  flow  of  specie.  Thus 
far  we  have  been  illustrating  the  principles  involved  in  foreign 
exchange  by  reference  to  the  trade  and  financial  relations  that 
obtain  between  the  United  States  and  Great  Britain.  The 
mechanism  of  the  exchanges  also  makes  it  possible  for  a  round- 
about settling  of  balances  involving  three  or  more  countries; 
for  instance,  there  has  long  been  a  triangular  trade  situation 
involving  the  United  States,  Great  Britain,  and  Brazil.  The 
United  States  imports  from,  more  than  she  exports  to,  Brazil; 
Great  Britain  has  an  unfavorable  balance  with  the  United 
States;  and  Brazil's  imports  from,  exceed  her  exports  to,  Great 
Britain.  Thus  Great  Britain  owes  the  United  States,  the 
United  States  owes  Brazil,  and  Brazil  owes  Great  Britain. 
The  exchanges  make  it  possible  for  the  United  States  to  pay 
for  her  imports  from  Brazil  by  bills  of  exchange  drawn  against 
London  bank  accounts,  such  bills  being  acceptable  because 
they  can  be  used  in  paying  Brazilian  obligations  to  Great 
Britain.  In  a  similar  way,  since  Canada  commonly  has  an 
adverse  balance  with  the  United  States,  but  a  favorable  balance 
with  England,  it  is  usually  advantageous  all  around  for  Canadian 
importers  from  the  United  States  to  meet  their  obligations  by 
means  of  bills  of  exchange  drawn  against  London  banks  by 
Canadian  exporters  to  Great  Britain. 


114         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Foreign-exchange  dealers  or  traders  also  assist  in  this  process 
of  roundabout  settlement  by  arbitrage  transactions.  The 
skilful  trader  makes  a  careful  study  of  the  quotations  in  all 
the  foreign-exchange  markets  at  any  given  time.  By  virtue  of 
temporary  variations  in  rates  on  different  countries  he  may 
make  a  slight  profit  by  bu)ang  exchange  in  one  market  and 
selling  simultaneously  in  another.  These  arbitrage  transactions 
often  involve  several  markets,  and  they  thus  tend  to  stabihze 
all  the  exchanges  and  hold  them  upon  a  common  level,  with 
movements  of  currency  a  last-resort  measure. 

In  any  given  year  the  United  States,  then,  will  have  a  net 
outflow  or  net  inflow  of  gold  as  a  result  of  variations  in  the 
relative  demand  for,  and  supply  of,  bills  of  exchange,  arising 
from  trade  and  financial  operations  with  all  the  world.  Statis- 
tics of  international  currency  movements  are  usually  presented 
by  the  year;  for  example,  in  the  year  1910  the  United  States 
would  show  a  net  inflow  of  gold  of,  say,  $100,000,000.  It  is  im- 
portant to  note,  however,  that  during  certain  months  or  weeks  of 
the  year  gold  may  be  flowing  out  of  a  country  and  during  other 
months  or  weeks  it  may  be  flowing  in,  the  direction  of  the  flow 
depending  upon  seasonal  variations  in  the  trade  and  financial 
relations  between  different  countries.  In  the  United  States 
there  is  normally  a  surplus  of  foreign  bills,  with  a  consequent 
depression  of  exchange  rates  to  the  gold-importing  point 
during  the  autumn  and  early  winter,  when  American  exports 
of  cotton  and  wheat  are  large.  In  the  spring,  when  American 
imports  of  British  textiles  and  other  manufactured  goods  are 
heaviest,  exchange  rates  are  frequently  bid  up  to  the  exporting 
point. 

m.    THE  MAINTENANCE  OF  EQUILIBRIUM 

This  mechanism  of  the  exchanges,  as  we  have  seen,  permits 
an  outflow  of  specie  from  the  United  States  whenever  the  total 
of  foreign  obligations  that  must  be  met  is  greater  than  is  the 
volume  of  remittances  due  us.  Under  normal  circumstances  an 
outflow  of  gold  from  any  country  cannot  continue  long,*  for  it 

*  Ebtcept  from  a  gold-producing  country. 


THE  FOREIGN  EXCHANGES  115 

is  soon  followed  by  financial  and  trade  readjustments  which  will 
shortly  restore  the  balance.  An  outflow  of  gold  from  the 
United  States  to  England,  for  instance,  would  mean  a  lessened 
volume  of  funds  in  New  York,  with  a  tendency  for  interest  rates 
to  rise  there.  The  inflow  of  funds  to  the  London  banks  would 
at  the  same  time  tend  to  lower  interest  rates,  in  London. 
In  consequence  international  bankers  would  find  it  profitable 
to  transmit,  by  means  of  bills  of  exchange,  funds  from  London 
to  New  York,  thus  serving  to  restore  the  equilibrium  of  the 
exchanges  and  to  prevent  a  further  outflow  of  gold  from  New 
York,  if  not  to  bring  about  a  reverse  movement. 

It  is  the  generally  accepted  economic  theory  that  if  an 
outflow  of  gold  from  the  United  States  to  England  should 
continue  for  any  considerable  length  of  time  it  would  eventually 
cause  a  rise  in  prices  in  England  and  a  fall  in  prices  in  the 
United  States;  whereupon  American  producers  would  find 
it  more  profitable  to  export  than  to  sell  in  the  domestic  market, 
while  American  importers  would  find  it  less  profitable  to  import 
commodities  from  a  country  with  a  high  price  level  for  sale  in 
a  coimtry  with  a  low  price  level.  The  same  factors  would 
obviously  be  operating  on  the  British  side,  and  English  traders 
would  strive  to  reduce  exports  and  increase  imports.  Accord- 
ingly, the  volume  of  exports  would  be  somewhat  increased 
and  the  volume  of  imports  somewhat  lessened.  There  would 
result  a  favorable  balance  of  trade,  and  gold  would  flow  back  to 
the  United  States,  thus  restoring  the  international  equilibrium. 

IV.    DOMESTIC  EXCHANGES 

The  foreign  exchanges  find  their  counterpart  in  domestic 
exchange,  that  is,  in  the  settlement  of  balances  between  the 
different  financial  centers  of  any  given  country.  The  domestic- 
exchange  quotations  are  different,  however,  by  virtue  of  the 
fact  that  the  same  monetary  unit  exists  in  New  York  as  in 
Chicago,  in  Liverpool  as  in  London.  Par  of  exchange  between 
New  York  and  Chicago  is,  therefore,  $1 ;  that  is  to  say,  the 
dollar  in  Chicago  is  to  the  doUar  in  New  York  as  i  is  to  i. 


Il6         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

At  any  given  time  there  are  numerous  obligations  of  various 
types  which  require  a  remittance  of  funds,  or  "means  of  pay- 
ment," from  New  York  to  Chicago,  and  vice  versa.  When 
the  balance  due  New  York  exceeds  the  balance  due  Chicago, 
exchange  on  New  York  is  at  a  premium,  that  is,  above  par. 
Since  the  c«st  of  moving  specie  from  Chicago  to  New  York 
is  about  50  cents  per  thousand  dollars,  one  would  pay  as  much 
as,  but  not  more  than,  $1,000.50  for  a  bill  of  exchange  with 
which  to  meet  a  thousand-dollar  payment  in  New  York.  And 
one  would  never  have  to  sell  a  thousand-dollar  bill  of  exchange 
on  New  York  for  less  than  $999.50. 

Between  the  different  financial  centers  of  the  United  States, 
as  between  foreign  countries,  specie  moves  only  as  a  last  resort. 
As  in  the  case  of  international  operations,  the  amount  of  specie 
reflects  the  net  balance  of  trade  and  financial  obUgations. 
As  with  international  operations,  also,  an  important  factor  is 
always  the  transmitting  of  bank  balances  from  one  center  to 
another  through  the  purchase  and  sale  of  bills  of  exchange. 
There  are  also  triangular  settlements,  as  between  St.  Louis, 
New  Orleans,  and  New  York. 

At  certain  seasons  of  the  year,  however,  the  balance  against 
Chicago  is  such  that  specie  moves  from  Chicago  to  New  York; 
at  other  seasons  funds  move  west.  And  when  at  the  end  of 
the  year  the  net  figures  are  shown,  Chicago  and  vicinity  will 
have  had  a  net  favorable,  or  unfavorable,  balance  with  New 
York  and  vicinity.  But,  as  with  international  operations, 
once  more,  there  cannot  be  a  continuous  flow  of  funds  from 
Chicago  to  New  York,  or  vice  versa,  because  changes  of  interest 
rates  and  ultimate  changes  of  price  levels  bring  in  their  train 
readjustments  which  cause  a  reversal  of  trade,  and  thus  lead 
to  the  restoration  of  the  balance. 

V.    FOREIGN  EXCHANGE  DURING  THE  WAR 

At  the  outbreak  of  the  European  war  the  normal  adjust- 
ments of  international  trade  and  financial  obligations  were 
very  quickly  disrupted.    In  the  autumn  of  1914  there  was  a 


The  foreign  exchanges  117 

great  rush  on  the  part  of  European  holders  of  American  securi- 
ties to  sell  them  back  to  us  as  a  means  of  securing  funds  required 
for  war  purposes.  At  the  same  time  the  usual  fall  movement 
of  our  cotton  and  other  products  was  checked  both  by  a  tempo- 
rary decline  in  European  demands  and  by  the  fear  of  German 
raiders.  Insurance  rates  also  tremendously  increased,  so  that  the 
gold-exporting  point  no  longer  remained  at  4 .  885.  So  great  was 
the  demand  for  sterling  bills  as  compared  with  the  supply  that 
sterUng  exchange  rose  at  one  time  as  high  as  $7.00,  though 
it  soon  decUned  to  $5.00,  a  figure  still  substantially  above  the 
previous  maximum. 

In  the  autumn  of  1915,  however,  when  Great  Britain 
began  to  buy  great  quantities  of  war  supplies  in  the  United 
States  the  situation  was  sharply  reversed:  the  supply  of  bills 
of  exchange  outran  the  demand,  and  exchange  quickly  fell  to 
the  gold-importing  point.  For  a  time  Great  Britain  attempted 
to  maintain  the  normal  method  of  correcting  adverse  exchanges 
by  allowing  an  export  of  gold,  but  this  had  to  be  checked  before 
long  because  of  the  disastrous  consequences  to  the  British 
monetary  system. 

The  balance  of  payments  continued  to  run  so  heavily  in 
favor  of  the  United  States  that  sterling  declined  to  4.48,  at 
which  point  the  British  government  intervened,  checked  further 
depreciation,  and  restored  the  rate  to  about  4.76^,  where  it 
remained  "pegged"  until  March,  191 9.  This  pegging  of  the 
exchanges  was  accomplished  chiefly  through  sales  by  the  British 
government  of  American  securities  which  were  taken  over  from 
British  owners,  and  by  government  loans  from  the  United 
States. 

VI.    THE  POST-WAR  DEPRECIATION  OF  THE 
EUROPEAN  EXCHANGES 

With  a  view  to  effecting  a  gradual  restoration  of  the 
normal  functioning  of  the  international  exchanges,  the  British 
government,  four  months  after  the  conclusion  of  the  armistice, 
abandoned  control  of  exchange  rates;  and  similar  action  was 
shortly  taken  by  France,  Italy,  and  other  countries.    For 


Il8         THE  FINANCIAL  ORGANIZATION  OF  'SOCIETY 

reasons  to  be  discussed  elsewhere  (see  p.  270  below),  European 
embargoes  on  gold  shipments  were,  however,  still  retained; 
hence  the  normal  corrective  of  depreciated  exchanges  remained 
inoperative.  The  results  of  the  international  economic  mal- 
adjustments occasioned  by  the  war  were  quickly  shown  in  a 
sharp  fall  in  exchange  rates  on  all  these  countries. 

One  reason  for  the  decline  may  be  easily  seen  by  a  brief 
consideration  of  some  of  the  changes  that  have  occurred  in  the 
financial  and  trade  transactions  enumerated  on  page  108  above. 
As  between  the  United  States  and  England,  for  instance, 
interest  on  British  investments  has  largely  ceased  because  of  the 
return  of  American  securities.  On  the  other  hand,  we  have 
lent  huge  sums  to  Great  Britain,  so  that  heavy  interest  pay- 
ments were  due  us  instead.  British  shipping  has  been  reduced 
by  submarine  destruction;  but  American  shipbuilding  has 
increased,  with  the  result  that  the  American  debt  to  Great 
Britain  on  account  of  freight  charges  is  now  much  less  than 
formerly.  Tourist  travel  in  England  is  for  the  present  almost 
negligible;  and  finally,  the  balance  of  trade  is  temporarily 
tremendously  in  our  favor,  owing  to  the  necessity  for  England  to 
import  large  quantities  of  raw  materials,  as  well  as  food-stuffs, 
until  such  time  as  her  own  industries  can  be  rehabilitated  for 
the  purposes  of  peace.  These  same  general  factors  hold  in 
exaggerated  fashion  as  between  the  United  States  and  the 
Continental  beUigerents. 

An  idea  of  the  magnitude  of  the  changes  that  have  occurred 
may  be  gained  from  a  consideration  of  the  following  figures: 
Before  the  war  we  owed  foreign  nations  about  $6,500,000,000, 
on  which  the  annual  interest  charges  amounted  roughly  to 
$300,000,000.  During  the  war  we  bought  back  nearly  five 
billions  of  these  securities,  and  loaned  to  the  Allies  about 
$10,000,000,000  on  government  account  and  about  $2,000,000,- 
000  on  private  account,  the  interest  charges  on  which  amount 
to  about  $600,000,000  annually.' 

'  Another  important  factor  in  the  post-war  depreciation  of  European 
exchanges  is  the  irredeemable  paper  currency  of  all  of  the  belligerent  coun- 
tries.   See  pp.  270-73  below. 


THE  FOREIGN  EXCHANGES  1 19 

For  a  discussion  of  the  economic  consequences  of  the  de- 
preciation of  the  exchanges  wrought  by  the  maladjustments 
of  the  war,  and  the  remedy  that  has  been  suggested,  the  reader 
is  referred  to  chapter  xv  below. 

QUESTIONS  FOR  DISCUSSION 

1.  Enumerate  as  many  sources  of  international  obligations  as 
possible,  in  addition  to  those  listed  on  page  108. 

2.  Why  is  it  that  specie  alone  is  acceptable  in  settling  the  balance 
of  international  obligations  ? 

3.  Define  parity  of  exchange;  gold  points;  premium;  discount. 

4.  What  data  would  you  require  in  order  to  ascertain  the  parity  of 
exchange  between  United  States  and  Japanese  money  ? 

5.  What  is  the  service  performed  by  the  banks  in  connection  with 
settling  trading  obligations  by  means  of  bills  of  exchange? 

6.  Show  by  a  concrete  illustration  how  bankers  may  find  it  profitable 
to  draw  finance  bills  when  exchange  is  below  par.  What  is  the 
effect  of  such  purchases  upon  the  volume  of  currency  shipments  ? 

7.  Describe  the  process  by  which  each  nation  is  required  to  settle 
with  actual  currency  only  its  net  balance  with  all  the  rest  of  the 
world. 

8.  What  is  meant  by  finance  bills  ?  Do  they  affect  exchange  rates 
in  the  same  way  as  trade  bills  ? 

9.  What  will  determine  whether  the  United  States  has  an  inflow  or 
outflow  of  gold  in  a  given  week  or  month  ? 

10.  Describe  the  process  by  which  the  international  financial  equi- 
librium is  maintained. 

11.  In  the  light  of  the  exchange  mechanism  is  there  any  reason  to 
fear  an  inundation  of  American  markets  by  cheap  foreign  goods  ? 

12.  In  the  light  of  foreign-exchange  analysis  do  you  accept  the 
doctrine  that  an  excess  of  exports  gives  a  "favorable"  balance  of 
trade  ? 

13.  Under  what  circumstances  would  an  inflow  of  gold  into  a  country 
be  particularly  advantageous  ?  Under  what  circumstances  would 
an  outflow  be  disadvantageous?  Give  concrete  illustrations,  if 
possible. 

14.  One  of  the  leading  bankers  of  this  coimtry  stated  in  1916  that  the 
United  States  had  received  a  great  inflow  of  gold  and  that  means 
must  be  devised  to  prevent  its  outflow  in  the  future.  Since  this 
banker  was  engaged  in  international  financial  operations,  do  you 


I20         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

imagine  the  activities  of  his  bank  were,  in  fact,  directed  toward 
impounding  this  gold  supply  for  the  permanent  use  of  America  ? 

15.  How  does  a  nation  which  does  not  produce  gold  secure  a  gold 
supply  ? 

16.  What  is  the  par  of  exchange  between  BerUn  and  Cologne? 
Paris  and  Berne  ?    London  and  Montreal  ? 

17.  Enumerate  the  chief  sources  of  obUgations  as  between  New  York 
and  Chicago. 

18.  What  caused  sterling  exchange  to  rise  to  $7  shortly  after  the 
-    outbreak  of  the  European  war  ?    Do  you  think  it  was  necessary 

for  the  European  nations  to  suspend,  as  a  war  measure,  the 
normal  operation  of  the  exchanges  ? 

19.  Indicate  the  changes  that  occurred  during  the  war  in  the  inter- 
national financial  relations  between  the  United  States  and  France, 
and  show  the  effect  of  each  upon  French  exchange. 

20.  By  what  means  were  the  exchanges  "pegged"  by  the  European 
governments  ? 

21.  During  the  war  we  loaned  in  the  neighborhood  of  $q,ooo,ooo,ooo 
to  the  Allies.  Of  what  did  such  loans  consist  ?  What  was  their 
relation  to  exchange  rates? 

22.  Why  should  this  war-time  control  of  the  foreign  exchanges  have 
been  abandoned  in  March,  1919?  What  would  have  been 
involved  in  a  continuance  of  the  policy  of  pegging  the  exchanges  ? 

23.  Draw  up  in  parallel  columns  a  statement  of  the  sources  of  inter- 
national obligations  that  now  obtain  between  the  United  States 
and  Great  Britain,  and  compare  them  with  the  statement  in  the 
text  showing  the  situation  before  the  war. 

24.  Look  up  in  the  financial  pages  of  the  press  the  present  exchange 
rates  between  the  United  States  and  the  principal  European 
countries. 

REFERENCES  FOR  FURTHER  READING 

Escher,  Franklin:  Elements  of  Foreign  Exchange,  chaps,  i,  ii,  iii, 
and  v. 

Johnson,  Joseph  French:  Money  and  Currency,  chap.  v. 

Phillips,  Chester  A.:  Readings  in  Money  and  Banking,  chaps, 
xvii  and  xviii. 

Scott,  William  A.:  Money  a)td  Banking,  chap,  viii,  pp.  121-31. 

Whitaker,  Albert  C:   Foreign  Exchange,  chap.  v. 

Withers,  Hartley:  Money  Chan^in^,  chaps,  ii,  viii,  and  ix. 


CHAPTER  IX 

THE  NATURE  AND  FUNCTIONS  OF  CREDIT 

With  this  chapter  we  pass  from  a  study  of  the  nature  and 
functions  of  money  to  a  consideration  of  the  part  that  credit 
plays  in  the  general  economic  organization.  The  great  impor- 
tance of  the  institution  which  we  loosely  call  "credit"  finds 
emphasis  in  such  common  expressions  as:  "modern  industrial 
society  is  a  credit  society";  "credit  is  the  heart  and  core  of 
the  industrial  system";  and  "credit  is  the  life-blood  of  com- 
merce and  industry."  What  is  the  nature  of  this  striking 
phenomenon?  In  what  does  its  great  service  consist;  and 
why,  precisely,  does  it  occupy  so  prominent  a  position  in  the 
economic  system  of  today  ?  It  is  the  purpose  of  the  present 
chapter  to  consider  the  nature  of  credit  operations,  to  study 
the  numerous  types  or  classes  of  credit  that  exist  today,  and  to 
indicate  in  a  general  way  the  significance  of  the  institution 
of  credit  from  the  point  of  view  of  economic  organization.  It 
will  be  the  task  of  the  remainder  of  the  volume  to  disclose  in 
greater  detail  the  economic  functions  of  credit  and  to  indicate 
the  services  that  are  rendered  by  the  numerous  types  of  financial 
instruments  and  institutions  which  have  been  developed  in 
order  to  facilitate  credit  Operations. 

I.    THE  NATURE  OF  CREDIT 

In  simple  business  parlance,  credit  involves  merely  getting 
something  now  and  paying  for  it  later.  It  is  synonymous  with 
borrowing,  the  essential  element  in  credit  operations  always 
being  the  postponement  of  pajrment  for  something  that  has 
been  received.  It  is  important  to  bear  in  mind  that  the  thing 
loaned  (on  credit)  may  be  either  commodities  or  funds.  Goods 
sold  on  time  involve  credit;  indeed,  we  usually  say  that  such 
goods  are  sold  "on  credit."  Such  goods  may  be  paid  for  by 
a  return  of  goods  in  kind;   though  under  modern  conditions 

131 


122         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  obligation  is  usually  settied  by  money  payments.  Money 
loaned  by  a  bank  or  other  financial  institution,  or  by  one  indi- 
vidual to  another,  similarly  involves  a  future  payment,  the 
credit  consisting  in  allowing  the  individual  to  have  the  use  of 
funds  which  he  is  to  return  at  a  later  time. 

Practically  all  credit  operations  are  expressed  in  terms  of  the 
pecuniary  unit.  It  may  also  be  observed  that  it  is  in  connec- 
tion with  credit,  or  borrowing  operations,  that  the  standard 
of  deferred  payments,  discussed  in  chapter  iii,  finds  its  function 
in  industrial  society. 

While  credit  is  thus  closely  associated  with  the  monetary 
system,  it  should  not  be  confused  with  money,  and  the  reader 
should  be  especially  careful  to  distinguish  between  credit  and 
credit  instruments,  which  will  be  discussed  in  chapter  xi. 
Credit  is  a  loaning  operation  involving,  as  already  seen,  a  post- 
poned pa)anent;  credit  instruments,  on  the  other  hand,  are 
the  written  evidences  of  antecedent  credit  operations,  that  is, 
of  the  agreement  to  pay  at  a  future  date.  It  is  credit  instru- 
ments, not  credit,  as  will  be  seen  in  an  ensuing  chapter,  that 
serve  as  important  media  of  exchange. 

n.    THE  VARIOUS  KINDS  OF  CREDIT 

From  the  point  of  view  of  the  institutions  or  individuals 
utilizing  credit,  the  various  tj^^es  or  kinds  of  credit  operations 
that  exist  in  the  modern  world  have  been  classified  as  follows: 
pubUc  credit;  capital  credit;  mercantile  credit;  individual 
or  personal  credit;  and  banking  credit. 

By  public  credit  is  meant  chiefly  the  borrowing  operations 
of  governments,  whether  national,  state,  or  local,  through 
the  issue  of  securities.  The  government  t)T5ically  promises 
to  pay  interest  semiannually  and  to  meet  the  principal  at 
some  stated  future  date.  The  funds  borrowed  are  commonly 
devoted  to  public  enterprises  which  involve  large  initial  outlays 
and  the  benefits  of  which  are  to  be  spread  over  a  period  of  years. 
National  governments  of  course  often  borrow  for  war  purposes. 


NATURE  AND  FUNCTIONS  OF  CREDIT       123 

By  capital  credit,  or  industrial  credit,  to  employ  another 
term,  is  meant  the  credit  used  by  manufacturing  and  producing 
corporations  in  procuring  the  necessary  permanent  capital 
required  for  their  operations.  The  corporation  agrees  to  return 
to  the  purchaser  of  its  bonds  at  some  future  date  the  equivalent  of 
the  funds  borrowed,  with  interest.  The  purchaser  of  stocks  also 
in  a  sense  loans  funds  to  the  corporation  with  the  understand- 
ing that  he  is  to  receive  dividends  in  the  future  (if  earned)  and 
ultimately,  if  the  business  is  liquidated,  his  share  of  the  capital. 
It  is  the  usual  practice  to  exclude  from  capital  credit  the  invest- 
ments that  are  made  by  individuals  in  a  business  largely  their 
own,  such  as  a  partnership. 

Mercantile  credit  is  the  term  applied  to  the  borrowing 
operations  of  jobbers,  wholesalers,  commission  merchants,  and 
retailers  in  connection  with  the  movement  of  goods  from  first 
producer  to  ultimate  consumer.  Another  term  sometimes 
used  synonymously  with  mercantile  credit  is  commercial  credit. 
The  distinction  between  commercial  and  other  forms  of  credit 
is  made  clear  in  the  section  which  follows. 

Individual  or  personal  credit  obviously  takes  its  name  from 
the  fact  that  it  is  connected  with  individuals  rather  than  with 
pubhc  or  private  corporations.  Individuals  borrow  money 
from  acquaintances  and  from  financial  institutions  for  a  wide 
variety  of  purposes;  and,  more  important,  they  purchase  con- 
sumptive goods  on  time  from  retail  stores.  In  cities  the  goods 
thus  borrowed  are  usually  paid  for  at  the  end  of  each  month, 
except  in  cases  where  they  are  sold  on  the  instalment  plan. 
But  in  the  riu-al  communities  the  settlements  are  made  at 
much  longer  intervals,  usually  at  crop-selling  times,  when  the 
farmer's  ship  comes  home.' 

Banking  credit  relates  to  the  process  by  means  of  which 
banking  institutions  are  enabled  to  attract  the  funds  of  deposi- 
tors and  to  make  loans  and  create  obligations  payable  on 
demand,  that  are  not  backed  by  a  dollar-for-doUar  cash  reserve. 
This  will  be  discussed  fully  in  subsequent  chapters. 

'  This  practice  is  becoming  less  common,  however,  as  fanning  becomes 
better  organized. 


124         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

m.    INVESTMENT,  COMMERCIAL,  AND 
CONSUMPTIVE  CREDIT 

Viewing  credit  apart  from  the  borrowing  operations  of 
particular  institutions,  such  as  governments,  corporations, 
individuals,  etc.,  three  distinct  types  of  credit  operations 
may  be  distinguished,  namely,  investment,  conmiercial,  and 
consumptive  credit.  This  classification  regards  credit  from  the 
point  of  view  of  the  uses  to  which  the  funds  borrowed  are 
devoted,  and  thus  is  concerned  with  the  means  by  which  the 
obligations  created  are  to  be  met  at  maturity. 

Investment  credit  is  that  which  is  used  in  connection  with  the 
development  of  business  enterprises,  such  as  railroads,  factories, 
workshops,  stores,  farms,  mines,  etc.  The  funds  borrowed  are 
used  mainly  for  the  creation  of  "fixed"  or  durable  forms  of 
capital  goods;  hence  the  term  "fixed  capital."  In  consequence 
of  the  productivity  of  capital  goods,  the  borrower  plans  to  pay 
the  principal  of  the  loan  out  of  the  accumulated  earnings  of  the 
business  over  a  period  of  years.  Under  the  circumstances,  the 
credit  instruments  employed  usually  call  for  payments  several 
years  hence.* 

Commercial  credit  is  that  which  is  used  in  financing  the 
production,  manufacture,  and  marketing  of  goods,  in  operating 
an  estabUshment  as  a  going  concern.  In  contrast  with  the 
case  of  investment  credit,  the  borrower  is  here  usually  in  a 
position  to  repay  his  loan  in  a  very  short  period  of  time.  A 
concrete  case  will  serve  to  illustrate  the  difference.  Mr.  X,  a 
wholesaler,  borrows,  let  us  say,  $10,000  from  the  bank  and 
pin-chases  a  stock  of  goods  with  the  money.  In  the  course  of 
two  months  he  sells  these  goods  for  $12,000,  or  at  a  gross  profit 
of  20  per  cent,  the  goods  purchased  being  the  direct  means  of 
liquidating  the  loan.  Similarly,  the  manufacturer,  Mr.  Y. 
borrows  $20,000  with  which  to  operate  his  plant  and  equip- 
ment. In  the  course  of  three  months,  say,  he  has  produced 
and  sold  $25,000  worth  of  goods,  thus  being  enabled  to  repay 
his  loan  directly  from  the  uses  to  which  the  borrowed  funds 
were  put. 

'  See  pp.  151-61. 


NATURE  AND  FUNCTIONS  OF  CREDIT  125 

The  borrower  for  investment  purposes,  on  the  other  hand, 
invests  $10,000  in  a  factory.  He  does  not  contemplate  selling 
the  factory  within  a  few  weeks  or  months;  on  the  contrary, 
he  expects  to  use  it  for  many  years  as  the  basis  for  his  manu- 
facturing enterprise.  Ten  years  or  more  must  usually  elapse 
before  the  accumulated  profits  will  permit  the  repayment  of 
the  principal  of  the  loan.  Investment  credit  furnishes  capital 
for  the  development  and  maintenance  of  industries.  Commer- 
cial credit  provides  funds  for  running  or  operating  business 
establishments  engaged  in  the  producing,  manufacturing,  and 
marketing  of  goods.  It  is  by  means  of  the  former  that  the 
business  manager  assembles  land,  labor,  and  materials,  and 
constructs  permanent  and  durable  capital  goods;  it  is  by  means 
of  the  latter  that  the  business  manager  assembles  labor,  sup- 
plies, and  materials,  and  produces  and  markets  the  consumptive 
goods  required  by  society. 

Consumptive  credit  refers  to  the  granting  of  loans  or  the 
selling  of  goods  on  time  to  individuals  who  use  the  money  or 
the  goods  received  in  satisfying  consumptive  wants.  If  the 
obligations  thus  created  are  met  at  maturity,  it  will  not  be 
because  the  funds  or  property  borrowed  were  devoted  to 
productive  uses;  it  will  be  because  the  borrower  has  other 
sources  of  income.  Such  credit,  therefore,  usually  involves 
somewhat  greater  risk  of  non-payment  at  maturity,  particularly 
of  prompt  payment,  than  does  either  investment  or  commercial 
credit.* 

IV.    THE  BASIS  OF  CREDIT 

There  has  been  a  great  deal  of  discussion,  participated  in 
by  both  economists  and  practical  credit  men,  concerning  the 
essential  basis  of  a  credit  or  borrowing  operation.  Some 
writers  on  the  subject  have  stoutly  insisted  that  confidence  is 
the  basis  of  all  grants  of  credit;  that  if  one  did  not  have  confi- 
dence that  the  borrower  would  repay  a  loan  he  would  neve? 
think  of  making  the  loan,  save  on  grounds  of  friendship  or 
philanthropy.    Others  have  held  that  property,  rather  thar 

*  For  a  consideration  of  consumptive  credit  see  chap.  xxviiL 


126         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

confidence,  is  the  basis  of  all  genuine  credit  transactions.  And 
still  others  insist  that  character  is  the  essential  factor;  while 
some  recent  writers  have  indulged  a  propensity  for  alliteration 
by  stating  that  the  bases  of  credit  are  character,  capital,  and 
capacity;  or  the  man  and  the  means;  or  reUability  and 
resources. 

Without  attempting  to  enter  into  a  discussion  of  the  reasons 
for  these  different  statements  of  the  basis  of  credit,  a  tabular 
exhibit  of  matters  commonly  investigated  by  competent  credit 
men  will  indicate  that  while  confidence  must  exist  before,  a 
loan  will  be  granted,  such  confidence  has  its  basis  in  a  knowledge 
of  the  borrower's  financial  standing  and  ability  and  of  his 
personal  integrity.  The  things  that  are  usually  investigated 
may  be  grouped  in  two  general  classes  as  follows: 

PERTAINING   TO  THE  MAN  PERTAINING   TO  THE  BUSINESS 

a)  Record  for  honest  dealing  c)  Ratio  of  quick  assets  to  cur- 

b)  Personal  attributes  rent  liabilities 

1.  Gambling    and    drinking      b)  Amount   of  capital  invested 
tendencies  and  property  owned 

2.  Political  and  other  "out-      c)  Earnings  of  business 

side"  activities  d)  Character  and  rate  of  tum- 

3.  Style  of  living,  including  over  of  stock 
wife's  social  ambitions  e)  Location  of  business 

c)  Ability  f)  Character    of    the    business 

1.  Conunon  sense  and  organization 
shrewdness  g)  Insurance  carried 

2.  Education   and   technical  h)  Nature  and  intensity  of  the 
training  competition 

3 .  Age  and  general  experience 

4.  Success  already  attained 

This  list  of  factors  is  by  no  means  inclusive;  it  is  designed 
merely  to  be  suggestive  of  the  character  of  the  investigation  that 
must  be  made  if  credit  is  to  be  conservatively  extended.  It 
will  be  noted,  also,  that  the  points  raised  in  the  parallel  columns 
are  not  entirely  unrelated,  A  man  of  excellent  business  ability, 
for  instance,  would  be  practically  certain  to  have  a  proper 


Credit Confidence 


NATURE  AND  FUNCTIONS  OF  CREDIT  127 

ratio  of  quick  assets  to  current  liabilities,  substantial  earnings 
etc.;  and,  on  the  other  hand,  if  it  were  found  that  a  business 
was  poorly  equipped  and  managed,  there  would  be  a  definite 
reflection  upon  the  manager's  business  capacity.  Investigation, 
both  of  the  man  and  of  the  business,  usually  serves,  however, 
to  fmnish  a  more  adequate  basis  for  a  sound  judgment  than 
investigation  of  either  one  alone. 

One  may  conclude  from  this  brief  analysis  that  before 
deciding  to  extend  credit  one  should  have  confidence,  first, 
in  the  abihty  of  the  borrower  to  pay  as  promised,  and,  second, 
in  his  willingness  and  intention  to  pay.  One  is  a  matter  of 
property  and  business  ability;  the  other  a  question  of  honesty 
and  business  integrity.  The  basis  of  credit  may  be  diagram- 
ma  tically  presented  as  follows: 

:.  Character  of  man 
(Intention  to  pay) 

!.  Character  of  business' 
(Ability  to  pay) 

V.    THE  SIGNIFICANCE  OF  CREDIT 

While  the  economic  significance  of  the  credit  system  cannot 
be  adequately  discussed  in  the  present  chapter,  a  few  of  the  ways 
in  which  credit  is  of  assistance  in  the  conduct  of  modern  afiFairs 
and  some  of  its  broader  social  aspects  may,  however,  be  sug- 
gested. 

Credit  enables  governments  to  obtain  possession  of' funds 
with  which  to  meet  pressing  emergencies,  when  no  other  means 
are  available.  It  also  enables  individuals  to  surmount  tempo- 
rary difficulties  or  embarrassments.  For  example,  it  makes  pos- 
sible the  purchase  of  goods  for  consumptive  requirements  pending 
the  receipt  of  income;  it  permits  the  purchase  of  a  home  before 
the  entire  purchase  money  is  in  hand;  and  it  makes  possible  the 
acquisition  of  an  education  on  borrowed  funds. 

Credit  makes  it  possible  for  honest  and  capable  men  without 
capital  to  secure  the  funds  required  for  the  conduct  of  modern 

'  Collateral  security  is  also  often  required.     See  pp.  386-90. 


128         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

industry.  Similarly,  it  enables  people  with  funds  in  excess  of 
their  immediate  needs  to  lend  the  surplus  to  capable  men  of 
affairs  who  utilize  them  in  productive  activities.  This  process 
(/lending  funds  tends  to  shift  "capital"  from  the  hands  of  those 
who  have  not  the  desire  or  the  abiUty  to  make  use  of  the  funds 
to  those  who  are  wilUng  and  able  to  assume  the  risks  of  capital- 
istic enterprise.  The  result  is  a  more  effective  utilization  of 
the  national  resources. 

The  abiUty  to  borrow  makes  it  possible  for  the  business 
manager  to  adjust  the  volume  of  his  capital  to  the  varying 
requirements  of  business.  When  the  demand  for  his  products 
is  very  large  at  certain  seasons  and  in  certain  years  of  extraordi- 
nary business  activity,  he  may  enlarge  the  volimae  of  output 
by  borrowing  additional  working  capital  and  in  dull  seasons 
and  years  he  may  reduce  the  volume  of  capital  employed.  This 
expansion  and  contraction  of  loans,  as  we  shall  later  see,  finds 
reflection  in  the  condition  of  the  commercial  banking  institutions 
which  constitute  the  foimdations  on  which  the  credit  structure 
is  reared.^ 

With  reference  to  the  broader  aspects  and  relations  of  the 
credit  system,  it  may  be  pointed  out  that  its  development 
has  depended  upon  the  growth  of  three  things:  first,  a  sense  of 
business  morality,  or  what  may  amount  to  the  same  thing,  a 
recognition  of  the  fact  that  honesty  is  the  best  policy;  second, 
a  relatively  stable  monetary  standard  for  deferred  payments; 
and  third,  a  legal  system  designed  to  safeguard  the  rights  of 
individuals  and  to  enforce  a  prompt  fulfilment  of  contracts. 
The  evolution  of  these  three  supports  of  the  credit  system 
has  been  one  of  the  most  significant  features  of  the  trans- 
formation from  medieval  to  modern  industrial  society.  All  of 
these  developments  have  been  very  closely  interrelated;  more- 
over, each  has  contributed  to,  and  each  has  been  accelerated 
by,  the  growth  of  the  credit  system. 

The  institution  of  credit  has  made  possible  the  growth  of 
large-scale  business  enterprise  and,  in  turn,  the  specialized 
industrial  society  of  the  present  time.     For  the  moment  industry 

*  Sec  chap,  xxiii  below. 


NATURE  AND  FUNCTIONS  OF  CREDIT  129 

passed  beyond  the  handicraft  stage,  each  enterprise  usually 
required  a  volume  of  capital  greater  than  could  be  furnished 
by  the  proprietors.  Accordingly  borrowing  became  an  indis- 
pensable handmaiden  of  business.  The  growth  of  the  capital- 
istic (profit-making)  system  of  industry  has,  moreover,  been 
marked  by  an  ever-enlarging  scale  of  business  enterprise,  insti- 
tuted, imder  the  competitive  regime  of  the  eighteenth  and 
nineteenth  centuries,  in  the  expectation  of  obtaining  larger 
profits  through  enlarged  output,  decreased  costs  of  production, 
and  lowered  selling  prices.  The  various  stages  in  the  trans- 
formation from  the  medieval  household  non-profit-making 
economy  to  the  twentieth-century  capitalistic  industrial  system 
are  outlined  in  chapter  xi  below.  It  need  merely  be  noted 
here,  therefore,  that  the  steadUy  expanding  scale  of  both 
industrial  and  commercial  undertakings  is  dependent  upon 
ever  enlarging  aggregations  of  capital,  the  assembling  of  which 
has  been  made  possible  only  by  a  great  extension  of  the  credit 
system,  whereby  funds  might  be  raised  for  a  given  enterprise 
from  a  veritable  multitude  of  individual  investors.  Small 
accumulations  of  capital  which  could  not  be  effectively  utilized 
by  their  owners  are  thus  joined  with  other  accumulations  and 
placed  imder  the  control  and  management  of  individuals  who 
are  able  to  make  the  most  effective  use  of  capital  resources. 

Since  nearly  every  business  enterprise  is  nowadays  in  greater 
or  lesser  degree  dependent  on  the  use  of  borrowed  funds,  it 
is  not  difficult  to  understand  why  writers  should  stress  the 
importance  of  credit  in  the  extravagant  terms  noted  in  the 
introductory  paragraph  of  this  chapter.  Credit  is  in  truth  a 
pervasive,  fundamental  institution — one  that  is  indispensable 
to  the  conduct  of  a  capitalistic  industrial  system. 

QUESTIONS  FOR  DISCUSSION 

1.  Give  a  definition  of  credit. 

2.  What  is  the  difference  between  credit  and  credit  instruments? 

3.  Do  you  know  of  any  businesses  that  do  not  borrow  at  all? 

4.  Give  concrete  illustrations  of  borrowing  operations  that  take 
the  form  of  the  borrowing  of  actual  goods.  Are  the  operations 
settled  by  a  return  of  goods  in  kind  ? 


I30  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

5.  Give  concrete  illustrations  of  borrowing  operations  that  take  the 
form  of  the  borrowing  of  money  or  "funds." 

6.  With  what  function  of  money  is  credit  most  closely  associated  ? 

7.  What  are  the  bases  for  the  two  different  classifications  of  credit 
given  in  the  chapter  ? 

8.  Which  classification  do  you  regard  as  more  significant  ?    Why  ? 

9.  What  is  the  essential  distinction  between  commercial  arid  in- 
vestment credit,  that  of  the  length  of  time  for  which  the 
credit  is  extended  or  the  use  to  which  the  funds  borrowed  are 
devoted  ? 

10.  What  is  the  explanation  of  the  fact  that  investment  credit  usually 
runs  for  long  periods  of  time  and  commercial  credit  for  short 
periods? 

11.  Turn  to  the  chart  on  page  136  and  indicate  where  commercial 
credit  might  be  placed. 

12.  Where  would  "capital"  or  "industrial"  credit  appear  on  the 
chart?    Where  wotdd  "mercantile"  credit  appear? 

13.  Would  consumptive  credit  ordinarily  be  extended  for  a  shorter  or 
longer  period  than  commercial  credit  ?    Why  ? 

14.  Does  consumptive  credit  appear  upon  the  chart  on  page  136  ? 

15.  What  is  meant  by  the  statement  that  the  "basis  of  credit  is 
confidence  "  ? 

16.  As  a  business  proposition,  would  you  lend  a  man  fimds  on  the 
strength  of  his  moral  character  alone  ? 

17.  As  a  business  proposition,  would  you  lend  funds  to  a  man  on  the 
strength  of  his  ability  to  pay  alone  ? 

18.  Which  do  you  regard  as  more  important  in  credit,  the  character  of 
the  man  or  the  character  of  the  property  security  ? 

19.  "  The  law's  delays  and  the  law's  circumventions  f)ermit  property 
to  melt  away,  but  the  element  of  personal  honesty  and  the 
quality  of  eflficiency  do  not  change  with  time."  If  you  agree 
would  you  conclude  that  ability  to  pay  is  less  important  than 
determination  to  pay  ? 

20.  In  the  case  of  public  credit,  is  there  any  property  basis  for  credit  ? 

21.  Is  there  ever  any  doubt  of  the  intention  and  willingness  of  a 
government  to  pay  ? 

22.  Why  do  French  borrowers  have  to  pay  in  the  neighborhood  of 
10  per  cent  on  loans  placed  in  the  United  States  in  the  year  1920  ? 

23.  Is  the  basis  of  capital  or  industrial  credit  confidence  in  the 
management  or  in  the  property  of  the  corporation  ? 


NATURE  AND  FUNCTIONS  OF  CREDIT      13 1 

24.  The  railroads  now  have  to  pay  relatively  higher  interest  rates  on 
borrowed  funds  as  compared  with  other  industries  than  formerly. 
To  what  is  this  relative  decrease  in  credit  standing  attributable  ? 

25.  When  a  retailer  advertises:  "Your  credit  is  good;  cash  pay- 
ments not  required,"  on  what  is  he  basing  his  belief  that  his 
customers  will  prove  good  ? 

26.  When  a  small-town  retailer  sells  goods  on  credit,  does  he  make 
any  investigation  of  the  borrower  ? 

27.  When  Marshall  Field  &  Company  extend  credit  to  a  lawyer, 
allowing  him  to  pay  his  bills  monthly,  what  is  the  basis  of  the 
credit  ? 

28.  What,  in  general,  is  the  basis  of  consumptive  credit  ? 

29.  Do  you  think  it  is  true  that  large-scale  business  enterprise  would 
not  be  possible  without  the  institution  of  credit  ? 

30.  Could  we  have  a  specialized  industrial  society  without  credit  ? 

31.  In  what  way  would  you  say  that  the  institution  of  credit  lessens 
the  cost  of  producing  goods  ? 

32.  Draw  up  a  statement  showing  how  the  institution  of  credit  has 
made  it  easier  for  society  to  satisfy  its  wants. 

REFERENCES  FOR  FURTHER  READING 

Hagerty,  James  E.:  Mercantile  Credit,  chaps,  i,  iii,  and  v. 

Laughlin,  J.  Laurence:  Principles  of  Money,  pp.  71-88. 

Meyer,  Charles  A.:  Mercantile  Credits  and  Collectiofts,  chaps,  i 
and  viii. 

Prendergast,  William  A. :  Credit  and  Its  Uses,  chaps,  i  and  ii. 

Shaw  Banking  Series:   Credits  and  Collections,  chaps,  iv-viii. 

The  Credit  Monthly.  Published  by  the  National  Association 
of  Credit  Men. 


CHAPTER  X 

THE  MODERN  FINANCIAL  STRUCTURE 

The  great  growth  of  credit  operations  which  followed  the 
development  of  large-scale  business  enterprise,  particularly  that 
organized  on  the  corporate  basis,  has  been  attended  by  the 
development  of  an  extensive  and  interdependent  financial 
structure,  designed  to  facilitate  the  raising  of  the  funds  required 
for  capitalistic  industry.  The  great  number  of  financial  instru- 
ments, agencies,  and  institutions  that  are  utilized  in  connection 
with  the  borrowing  operations  of  producing,  manufacturing, 
and  mercantile  businesses  is  indicated  in  the  diagrams  on  the 
accompanying  pages/  The  diagrams  are  designed  merely  to 
enable  the  reader  to  visualize  the  financial  mechanism  as  a 
whole  and  to  afford  a  general  view  of  the  financial  structure 
of  society,  with  its  complex  interrelations,  as  a  preliminary 
to  the  detailed  study  of  the  numerous  particular  institutions 
which  will  constitute  the  subject-matter  of  the  succeeding 
chapters. 

The  diagrams,  however,  require  a  few  words  of  explanation 
and  qualification.  In  general,  the  purpose  is  to  show  the 
financial  institutions  and  agencies  that  are  employed  in  the 
assembling  of  the  capital  required  by  modern  business  enter- 
prise. It  is  of  note,  first,  that  the  financial  structure  involved  in 
the  raising  of  fixed  capital  for  individual  firms  and  partnerships, 
as  shown  on  the  first  diagram,  is  relatively  simple,  since  it  is 
largely  contributed  by  the  owner,  or  owners,  of  the  business. 
The  greater  complexity  of  the  second  diagram,  moreover,  is  an 
indication  that  the  development  of  the  very  intricate  and 
extensive  financial  organization  of  the  present  day  is  largely 
attributable  to  the  enormous  growth  of  the  corporate  form  of 
business  organization. 

*  For  a  diagram  showing  the  financial  structure  that  has  been  developed 
in  connection  with  agricultural  borrowing,  see  p.  650. 

139 


MODERN  FINANCIAL  STRUCTURE  133 

With  reference  to  the  corporation  diagram,  particularly, 
the  arrows  pointing  downward  from  fixed  capital  indicate  the 
movement  of  the  securities  that  are  issued  by  corporations 
through  the  financial  institutions  that  assist  in  marketing 
them  to  the  ultimate  purchasers,  who  in  the  last  analysis  furnish 
the  funds  to  the  corporation.  In  some  cases  the  securities  do 
not  find  lodgment  with  individual  investors  but  are  purchased 
by  financial  institutions,  as  is  indicated  by  the  arrows  which 
point  to  savings  banks,  insurance  companies,  etc.  In  these  cases, 
however,  the  funds  are  still  furnished  by  individual  savers, 
namely,  the  shareholders,  depositors,  etc.  These  financial  insti- 
tutions thus  serve  as  intermediaries  in  the  process  of  rendering 
individual  savings  available  for  the  uses  of  corporate  industry. 

The  stock  market  has  been  placed  at  one  side  of  the  diagram 
in  order  to  indicate  that  it  is  not  a  direct  intermediary  in  the 
marketing  of  securities.  It  is  rather  a  great  central  market 
place  which  is  made  use  of  by  nearly  all  of  the  various  types  of 
financial  institutions  in  connection  with  their  operations,  as  well 
as  by  the  ultimate  investors  in  securities.  All  of  these  relations 
will  be  made  clear  in  the  chapter  on  the  stock  exchanges.  The 
lines  connecting  the  stock  exchange  with  the  different  institu- 
tions are  designed  to  indicate  in  a  general  way  the  interrelations 
that  exist. 

Finally,  it  will  be  seen  that  the  commercial  banks  are 
directly  concerned  with  the  raising  of  working  capital,  and 
indirectly  associated  with  investment  banking  instituti(fns  in 
the  raising  of  fixed  capital.  Note  the  transverse  Hne  connect- 
ing commercial  and  investment  banks,  A  line  might  also  be 
drawn  from  the  commercial  banks  to  the  fixed  capital  side  of  the 
corporation;  for  to  a  considerable  extent  they  purchase  securi- 
ties directly  and  make  loans  to  corporations  for  fixed  capital 
purposes  (see  chap,  xxi  and  pp.  487-88). 

To  safeguard  against  misconception  it  is  necessary  to  state 
that  the  diagrams  could  not  be  made  to  reveal  all  the  phases  of 
the  modern  financial  structure  without  complicating  them  to 
the  point  of  obscurity.  It  will  be  well,  therefore,  to  point 
out  here  certain  things  which  they  do  not  indicate. 


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MODERN  FINANCIAL  STRUCTURE  135 

First,  although  a  line  is  drawn  from  the  corporation  direct 
to  the  purchaser  of  securities,  the  corporation  chart  fails  to 
convey  an  adequate  idea  of  the  vast  amount  of  capital  that  is 
raised  without  the  assistance  of  financial  intermediaries.  A 
very  great  number  of  oiur  corporations  have  raised  their  capi- 
tal by  direct  subscription;  indeed,  I  think  it  may  safely  be 
said  that  a  large  percentage  of  our  present-day  corporations 
secured  their  start  by  converting  individual  firms  or  partner- 
ships into  corporations  and  issuing  shares  of  stock  to  the 
owners.  There  are  many  "close"  corporations — those  which 
have  never  raised  any  funds  from  general  subscription. 
Among  some  of  the  more  important  of  such  corporations 
are:  most  of  the  great  New  England  cotton  mills;  several  of 
the  larger  chemical  companies;  the  Du  Pont  Powder  Com- 
pany; many  of  the  great  department  stores  in  all  the  large 
cities  of  the  country;  the  large  corporations  in  the  aluminum, 
brass,  zinc,  asbestos,  and  sulphur  industries;  and  the  great 
majority  of  financial  institutions.  Perhaps  the  most  conspicu- 
ous example  of  the  close  corporation  in  the  United  States 
at  the  present  time  is  the  Ford  Motor  Company.  As  a  result 
of  recent  acquisitions,  Mr.  Ford  and  his  son  are  said  to  be 
the  sole  proprietors  of  the  largest  privately  owned  business  in 
the  country. 

Second,  the  charts  do  not  reveal  the  raising  of  capital  by 
the  common  process  of  creating  a  surplus  through  setting  aside 
a  portion  of  the  earnings  for  an  expansion  of  the  business. 
A  tremendous  amount  of  capital  is  thus  raised,  especially  by 
corporations.  It  will  be  noted  that  this  method  merely  involves 
a  decision  of  the  directors  of  the  corporation  with  reference  to 
the  disposition  of  earnings. 

Third,  the  charts  reveal  only  those  credit  operations  which 
involve  the  borrowing  of  funds,  as  distinguished  from  actual 
goods.  Working  capital  in  part  takes  the  form  of  materials 
bought  on  credit.  A  retailer,  for  instance,  may  do  most  of 
his  borrowing  by  buying  goods  from  wholesalers  on  time.  But 
since  the  wholesalers,  who  sell  these  goods  on  credit  to  the 
retailer,  usually  borrow  from  the  conunercial  banks  during  the 


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MODERN  FINANCIAL  STRUCTURE  137 

interval  while  awaiting  payment,  it  all  comes  to  much  the 
same  thing  in  the  end — working  capital  is  largely  borrowed  from 
the  commercial  banks. 

The  corporation  chart  does  indicate,  however,  that  a  portion 
of  the  working  capital  is  usually  derived  from  the  sale  of  securi- 
ties. Indeed,  if  a  business  is  to  have  a  good  credit  standing 
with  its  bank,  it  must,  in  fact,  provide  a  considerable  part 
of  its  working  capital  by  stock  subscriptions. 

Fourth,  one  might  conclude  from  the  corporation  diagram 
that  savings  banks  are  associated  only  with  the  problem  of 
raising  fixed  capital.  As  a  matter  of  fact,  many  savings-bank 
loans  are  also  made  for  working  capital  purposes  (see  chap.  xvii). 

Fifth,  the  position  of  the  trust  company  in  the  financial 
structure  of  society  is  not  adequately  revealed.  As  the  chart 
stands,  the  trust  company  is  related  only  to  the  raising  of  fixed 
capital  and  is  placed  in  a  parallel  position  with  savings  banks 
and  insurance  companies.  In  fact,  as  we  shall  later  see  (chap, 
xviii  below),  the  trust  company  performs  so  wide  a  variety  of 
fimctions  that  it  is  impossible  in  the  present  diagram  to  indi- 
cate its  relationship  to  the  entire  financial  structure.  The  com- 
mercial banking  department  of  the  trust  company  would  go 
with  the  conmiercial  banks,  the  bond  department  with  the  bond 
houses,  the  savings  department  with  the  savings  banks,  the 
insurance  department  with  the  insurance  companies.  But, 
in  addition,  the  trust  company  performs  a  great  variety  of 
services  for  the  holders  of  corporate  securities  in  connection  with 
the  safekeeping  of  valuables,  the  holding  of  mortgages  in  trust, 
the  transfer  of  ownership  of  stocks  and  bonds,  the  financial 
reorganization  of  companies,  etc. 

Finally,  the  diagrams  tend  to  give  a  false  impression  of 
specialization  by  financial  institutions.  The  truth  is  that  more 
and  more  there  is  being  conducted  under  one  roof  and  by  a 
single  administrative  organization  a  great  variety  of  financial 
activities.  Just  as  the  trust  company  has  many  departments, 
the  commercial  bank  nowadays  usually  has  associated  with  it 
savings  and  bond  departments,  and,  in  the  last  two  or  three 
years,  trust  departments  as  well.    The  designations  given  on 


138         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  diagram  must,  therefore,  be  considered  as  representing  types 
of  financial  functions  rather  than  (in  every  case)  distinct  and 
specialized  financial  institutions.' 

The  remaining  chapters  of  the  volume  will  be  devoted  to  a 
discussion  of  the  services  and  functions  that  are  performed  by 
the  numerous  parts  of  this  financial  organization,  the  problems 
of  regulation  that  have  arisen  in  connection  with  the  various 
types  of  financial  institutions,  and  the  interrelations  of  this 
intricate  financial  mechanism  with  the  larger  economic  organi- 
zation of  which  it  forms  so  important  a  part. 

'  See  chap.  zziz. 


CHAPTER  XI 

THE  CORPORATION  AS  A  DEVICE  FOR 
RAISING  CAPITAL 

At  the  head  of  the  diagram  showing  the  financial  institutions 
and  agencies  that  function  in  the  raising  of  capital  in  the  modern 
industrial  world  (p.  136)  is  placed  the  corporation,  the  domi- 
nant type  of  business  organization  at  the  present  time.  In 
discussions  of  the  corporation  as  a  form  of  organization  for  the 
conduct  of  business,  its  advantages  over  the  partnership  have 
usually  been  hsted  as  follows:  (i)  greater  ease  of  raising  capital; 
(2)  perpetual  (or,  at  least,  definite)  existence;  (3)  centralization 
of  managerial  responsibility  and  power.  It  is  the  purpose  of 
the  present  chapter  to  outline  the  significance  of  the  corporation 
as  a  capital-raising  institution — to  account  for  its  origin  and 
development  in  terms  of  capital  requirements. 

It  is  not  too  much  to  say  that  the  outstanding  advantage  of 
the  corporation  over  the  partnership  is  its  greater  effectiveness 
in  assembling  the  capital  required  for  large-scale  enterprise. 
Partnerships  may  be — and  some  have  been — ^iven  a  perpetual 
Ufe.  Partnerships  may  delegate  the  management  to  a  single 
individual  or  group  of  individuals  and  hold  them  responsible  for 
results,  quite  after  the  fashioij  of  the  corporate  organization. 
Indeed,  some  modern  partnerships  are  thus  organized;  while 
the  "silent  partner"  is,  of  course,  a  common  phenomenon. 
But  without  shares  of  stock  and  bonds  and  without  the  prin- 
ciple of  hmited  liability  the  partnership  could  not  possibly 
effect  the  accumulation  of  the  large  quantities  of  capital  required 
by  the  great  majority  of  modern  businesses.  Some  modem 
partnership  associations,  it  is  true,  have  the  equivalent  of 
shares  and  some  have  been  organized  with  a  limited  liability; 
but  these  features  constitute  the  very  essence  of  the  corporate 
form  of  organization.    To  the  extent  that  they  have  now  been 

139 


I40         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

taken  over  by  partnerships  the  lattejr  may  be  said  to  have 
"  corporationized . ' ' 

I.    ADVANTAGES  OF  THE  CORPORATION  IN 
RAISING  CAPITAL 

The  corporation  is  for  several  reasons  an  effective  agency 
for  the  raising  of  capital.  In  the  first  place,  the  division  of 
the  capital  into  small  units  in  the  form  of  shares  of  stock  or 
bonds  makes  it  possible  to  attract  funds  from  people  of  very 
moderate  means.  To  this  end  the  par  value  of  bonds  and  of 
shares  of  stock  is  made  small,  often  very  small  in  the  case  of 
shares.  While  the  standard  unit  is  $ioo,  many  companies  are 
organized  that  sell  shares  at  $io,  $5,  $i,  and  even  at  5  cents  each 
Investments  are  thus  brought  within  the  reach  of  every  class. 

Second,  the  division  of  the  shares  and  bonds  of  corporations 
into  small  denominations  also  makes  it  possible  for  individuals 
to  diversify  their  investments  and  thus  reduce  the  risks  of  loss 
to  a  minimum.  Even  so  small  a  fund  as  $10,000  may  be 
invested  in  a  hundred  or  more  different  companies.  It  is  of 
note  that  "baby  bonds,"  of  $100  denominations,  and  with 
instalment-payment  provisions,  have  become  increasingly 
popular  in  recent  years. 

Third,  the  division  of  corporate  securities  into  bonds  and 
shares  serves  to  attract  the  investments  of  people  of  different 
temperaments  and  of  different  economic  position.  Bonds, 
constituting  a  first  claim  upon  earnings,  make  their  appeal  to 
those  who  are  by  temperament  conservative,  or  whose  economic 
position  is  such  as  to  make  safety  of  investment  the  prime 
requisite.  On  the  other  hand,  stock  offers  an  opportunity  of 
higher  returns  and  thus  appeals  to  people  who  are  wilUng  to 
take  chances  in  the  hope  of  large  rewards,  and  to  those  whose 
economic  position  is  such  that  they  can  afford  to  assume  larger 
risks. 

Similarly,  the  division  of  stock  into  preferred  and  common 
shares  is  calculated  to  appeal  to  investors  of  different  degrees 
of  conservatism.  The  preferred  stock,  while  not  so  safe  as 
bonds,  is  still  relatively  safe  in  well-established  companies, 


THE  CORPORATION  AND  THE  RAISING  OF  CAPITAL      141 

and  it  yields  a  higher  return  than  bonds.  Common  stock  is 
subject  to  still  greater  risks,  but  affords  the  possibility  of  very 
large  returns.  Nowadays  there  is,  moreover,  a  great  variety 
of  subclasses  of  shares,  notes,  and  bonds,  all  designed  to  facili- 
tate the  raising  of  funds  through  varied  appeals.^ 

Fourth,  the  easy  transferability  of  bonds  and  shares,  made 
possible  by  the  development  of  organized  stock  exchanges, 
enables  an  individual  to  withdraw  his  investment  in  a  corpora- 
tion at  almost  a  moment's  notice.  The  significance  of  this  for 
our  present  purpose  is  that  the  ease  with  which  one  may  get 
out  of  a  corporation  has  an  important  bearing  on  his  willingness 
to  get  in.  Under  present  conditions  one  is  not  necessarily 
committed  to  a  given  undertaking  once  and  for  all;  with 
readily  marketable  securities  the  investor  retains  almost 
instantaneous  command  over  capital. 

Fifth,  the  large  aggregations  of  capital  made  possible  by 
virtue  of  these  various  advantages,  together  with  the  limited- 
liability  principle  discussed  below,  give  to  the  corporation 
unusual  competitive  strength  and  stability,  and  this  in  its 
turn  renders  securities  the  more  attractive  to  the  general 
investing  public. 

Sixth,  the  corporation  now  universally  embodies  the  prin- 
ciple of  limited  liability,  i.e.,  liability  of  each  shareholder  only 
to  the  amoimt  (usually)  of  his  individual  stock.  This  is 
indispensable  to  the  assembling  of  the  vast  amounts  of  capital 
required  by  modern  business  estabHshments,  for  it  would  be 
utterly  impossible  to  induce  an  individual  to  purchase  shares 
of  stock  in  a  corporation  of  large  size  if  his  individual  liabiHty 
to  creditors  was  equal  to  the  entire  capital.  Unhmited  liabiUty 
wiU  be  assumed  only  where  the  number  of  owners  is  few,  where 
they  are  well  known  to  each  other,  and  where  the  amounts 
involved  are  relatively  small. 

It  should  be  noted  that  the  principle  of  limited  liability 
applies  only  to  stock,  the  bondholders  being  creditors  of  the 
corporation.  It  is  apparent,  finally,  therefore,  that  even  with- 
out the  principle  of  limited  Uabihty  the  corporation  would  have 

*  See  pp.  155-56, 


142         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

advantages  over  the  ordinary  partnership  in  the  assembling 
of  capital,  since  the  sale  of  bonds  would  in  any  event  make  it 
possible  to  draw  funds  from  a  large  number  of  investors. 

The  growth  of  large-scale  enterprise  was  dependent  upon 
limited  liability.  Light  will  be  thrown  upon  the' importance  of 
the  principle  of  limited  liability  from  the  point  of  view  of  facili- 
tating the  raising  of  capital  by  a  brief  review  of  its  history.  For 
a  considerable  period  during  English  industrial  history,  joint- 
stock  companies  did  not  enjoy  the  principle  of  limited  liability. 
Following  a  period  of  great  speculation  in  the  shares  of  unincor- 
porated ''companies,"^  in  which  many  people  were  financially 
ruined,  the  so-called  Bubble  Act  of  17 19  prohibited  unincorpo- 
rated companies  from  acting  as  corporate  bodies  or  selling  trans- 
ferable stock.  This  prohibition  interfered  with  the  formation 
of  genuine  trading  companies  and  "greatly  hindered  the  employ- 
ment of  accumulated  capital."^  The  strict  enforcement  of  the 
act,  however,  was  found  to  be  impracticable  and  for  many  years 
it  was  allowed  to  remain  a  dead  letter,  many  new  unincorporated 
companies  continuing  to  be  formed. 

The  Bubble  Act  was  repealed  in  1825  and  the  Crown  was 
empowered  to  grant  charters  of  incorporation;  but  the  indi- 
vidual owners  of  the  corporation  were  made  personally  liable 
for  the  whole  or  any  part  of  the  debts  of  the  corporation. 
During  the  next  thirty  years  men  of  investment  and  social 
standing  held  aloof  from  concerns  in  which  the  smallest  invest- 
ment involved  so  great  a  risk.  Of  4,049  companies  registered 
provisionally  from  1844  to  1855,  3,084  were  abandoned  before 
complete  registration.  The  principle  of  limited  liability  was 
so  important,  however,  for  the  raising  of  the  capital  required 
for  the  rapidly  expanding  size  of  industrial  enterprises  that 
Parliament  finally  passed  an  act  in  1856  permitting  the  forma- 
tion of  corporations  "with  limited  or  unlimited  liability,  with 
all  the  benefits  of  incorporation."  Banking  and  insurance 
companies  were,  however,  still  excluded.    The  complete  accept- 

'  See  p.  144. 

»  S.  E.  Perry,  "History  of  Companies'  Legislation  in  England,"  Journal 
of  the  Ittititute  of  Bankers,  Vol.  XXIX. 


THE  CORPORATION  AND  THE  RAISING  OF  CAPITAL      143 

ance  of  the  limited  liability  principle,  together  with  the 
adoption  of  a  general  incorporation  law  by  the  act  of  1856, 
paved  the  way  for  the  great  expansion  in  the  size  of  business 
enterprise  that  marked  the  second  half  of  the  nineteenth 
century,' 

In  the  United  States,  however,  it  appears  that  the  principle 
was  accepted  from  the  very  beginning.  Davis  informs  us  that 
"limited  liability  was  recognized  as  an  attribute  of  an  incorpo- 
rated company  almost  invariably  without  specific  mention; 
indeed,  it  was  a  principal  object  desired  through  incorporation."* 
With  scarcely  an  exception,  early  American  corporations,  in 
fact,  enjoyed  the  advantages  incident  to  limited  liability. 

II.  STAGES  OF  CORPORATE  DEVELOPMENT 

A  study  of  the  changes  that  have  occurred  in  the  organiza- 
tion of  industry  from  the  Middle  Ages  to  the  present  time 
indicates  that  the  development  of  the  corporation  was  in 
truth  very  largely  governed  by  capital  requirements.  While 
the  germ  of  the  corporate  idea  is  no  doubt  to  be  found  in  the 
guild  associations  of  the  early  Middle  Ages,  the  first  corporations 
of  significance,  from  the  point  of  view  of  business  enterprise, 
were  the  great  trading  companies  of  the  sixteenth  and  seven- 
teenth centuries.  These  companies  were  organized  for  the 
purpose  of  developing  trade  with  foreign  dominions  and  as 
colonizing  agencies.^ 

The  early  corporation  embodied  numerous  features;  it 
was  a  bundle  of  special  rights  and  privileges,  and  has  been 
aptly  called  a  collection  of  monopoly  grants  of  power.  While 
there  was  no  single  reason  for  the  use  of  the  corporate  organiza- 
tion, large  capital  requirements  were  nevertheless  in  every 
case  the  paramount  factor.     The  shares  of  stock  of  small 

'  Loc.  cU. 

'Essays  in  Earlier  History  of  American  Corporations,  IV,  317-29. 

s  The  joint  stock  was  also  used  in  the  sixteenth  and  seventeenth  cen- 
turies in  mining  companies,  and  in  nearly  every  important  monopoly. 
Wm.  E.  Price,  English  Patents  of  Monopoly,  p.  131. 


144         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

denomination  made  it  possible  to  secure  capital  contributions 
from  a  large  number  of  individuals. 

Moreover,  unusual  risks  were  involved,  owing  to  the  un- 
certainties both  of  ocean  transportation  and  of  trade,  and  this 
was  a  serious  deterrent  to  the  advancement  of  large  sums  by 
any  one  individual.  The  joint-stock  company  made  it  possible 
for  individuals  to  distribute  their  risks  over  a  number  of  different 
undertakings. 

Investment  opportunities  were  few  before  the  corporate  era. 
These  early  corporations  were  necessary  not  only  for  the  raising 
of  capital  for  overseas  enterprises.  They  appear  to  have  been 
quite  as  serviceable  in  the  accommodation  of  would-be  investors. 
Macaulay^  writes: 

During  the  interval  between  the  Restoration  and  the  Revolution 
the  riches  of  the  nation  had  been  rapidly  increasing.  Thousands 
of  busy  men  found  every  Christmas  that,  after  the  expenses  of  the 
year's  housekeeping  had  been  defrayed  out  of  the  year's  income, 
a  surplus  remained;  and  how  that  surplus  was  to  be  employed  was  a 
question  of  some  difficulty.  In  our  time,  to  invest  such  a  surplus,  at 
something  more  than  three  per  cent  on  the  best  security  that  has 
ever  been  known  in  the  world,  is  the  work  of  a  few  minutes.  But  in 
the  seventeenth  century,  a  lawyer,  a  physician,  a  retired  merchant, 
who  had  saved  some  thousands  and  who  wished  to  place  them  safely 
and  profitably,  was  often  greatly  embarrassed.  Three  generations 
earlier,  a  man  who  had  accumulated  wealth  in  a  profession  generally 
purchased  real  property,  or  lent  his  savings  on  mortgage.  But  the 
number  of  acres  in  the  kingdom  had  remained  the  same;  and  the 
value  of  these  acres,  though  it  had  greatly  increased,  had  by  no 
means  increased  so  fast  as  the  quantity  of  capital  which  was  seeking 
for  employment.  Many,  too,  wished  to  put  their  money  where  they 
could  find  it  at  an  hour's  notice  and  looked  about  for  some  species  of 
property  which  could  be  more  readily  tranisferred  than  a  house 
or  a  field.  A  capitalist  might  lend  on  bottomry  or  on  personal 
security  but,  if  he  did  so,  he  ran  a  great  risk  of  losing  interest  and 
principal.  There  were  a  few  joint-stock  companies,  among  which 
the  East  India  Company  held  the  foremost  place;  but  the  demand 
for  the  stock  of  such  companies  was  far  greater  than  the  supply. 
Indeed,  the  cry  for  a  new  East  India  Company  was  chiefly  raised 

'  Quoted  in  Bagehot,  Lombard  Street  (1912),  pp.  131  ff. 


THE  CORPORATION  AND  THE  RAISING  OF  CAPITAL      14$ 

by  persons  who  had  found  difficulty  in  placing  their  savings  at  inter- 
est on  good  security.  So  great  was  that  difficulty  that  the  practice 
of  hoarding  was  common.  We  are  told  that  the  father  of  Pope,  the 
poet,  who  retired  from  business  in  the  City  about  the  time  of  the 
Revolution,  carried  to  a  retreat  in  the  country  a  strong  box  containing 
near  twenty  thousand  pounds,  and  took  out  from  time  to  time  what 
was  required  for  household  expense;  and  it  is  highly  probable  that 
this  was  not  a  solitary  case.  At  present  the  quantity  of  coin  which  is 
hoarded  by  private  persons  is  so  small  that  it  woiild,  if  brought  forth, 
make  no  perceptible  addition  to  the  circulation.  But  in  the  earlier 
part  of  the  reign  of  William  the  Third,  all  the  greatest  writers  on 
currency  were  of  opinion  that  a  very  considerable  mass  of  gold  and 
silver  was  hidden  in  secret  drawers  and  behind  wainscots. 

The  natural  effect  of  this  state  of  things  was  that  a  crowd  of  pro- 
jectors, ingenious  and  absurd,  honest  and  knavish,  employed  them- 
selves in  devising  new  schemes  for  the  employment  of  redundant 
capital.  It  was  about  the  year  1688  that  the  word  stockjobber  was 
first  heard  in  London.  In  the  short  space  of  foiu:  years  a  crowd  of 
companies,  every  one  of  which  confidently  held  out  to  subscribers  the 
hope  of  immense  gains,  sprang  into  existence — ^the  Insurance  Com- 
pany, the  Paper  Company,  the  Lutestring  Company,  the  Pearl 
Fishery  Company,  the  Glass  Bottle  Company,  the  Aliun  Company, 
the  Blythe  Coal  Company,  the  Swordblade  Company.  There  was  a 
Copper  Company,  which  proposed  to  explore  the  mines  of  England, 
and  held  out  a  hope  that  they  would  prove  not  less  valuable  than  those 
of  Potosi.  There  was  a  Diving  Company,  which  undertook  to  bring 
up  precious  effects  from  shipwrecked  vessels,  and  which  announced 
that  it  had  laid  in  a  stock  of  wonderful  machines  resembling  complete 
suits  of  armour.  In  front  of  the  helmet  was  a  huge  glass  eye  like 
that  of  a  Cyclops;  and  out  of  the  crest  went  a  pipe  through  which  the 
air  was  to  be  admitted.  The  whole  process  was  exhibited  on  the 
Thames.  Fine  gentlemen  and  fine  ladies  were  invited  to  the  show, 
were  hospitably  regaled,  and  were  delighted  by  seeing  the  divers  in 
their  panoply  descend  into  the  river  and  return  laden  with  old  iron 
and  ship's  tackle.  There  was  a  Greenland  Fishing  Company,  which 
could  not  fail  to  drive  the  Dutch  whalers  and  herring  busses  out  of  the 
Northern  Ocean.  There  was  a  Tanning  Company,  which  promised 
to  furnish  leather  superior  to  the  best  that  was  brought  from  Turkey 
and  Russia.  There  was  a  society  which  undertook  the  ofiice  of 
giving  gentlemen  a  Uberal  education  on  low  terms,  and  which  assumed 


146         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  sounding  name  of  the  Royal  Academies  Company.  In  a  pom- 
pous advertisement  it  was  announced  that  the  directors  of  the  Royal 
Academies  Company  had  engaged  the  best  masters  in  every  branch 
of  knowledge,  and  were  about  to  issue  twenty  thousand  tickets  at 
twenty  shillings  each.  There  was  to  be  a  lottery — two  thousand 
prizes  were  to  be  drawn;  and  the  fortunate  holders  of  the  prizes 
were  to  be  taught,  at  the  charge  of  the  company,  Latin,  Greek, 
Hebrew,  French,  Spanish,  conic  sections,  trigonometry,  heraldry, 
japanning,  fortification,  bookkeeping,  and  the  art  of  playing  the 
theorbo. 

The  second  stage  in  corporate  development  came  during 
the  seventeenth  and  eighteenth  centuries  when  the  corporate 
principle  was  extended  to  such  enterprises  as  insurance,  banking, 
and  inland  navigation.  The  importance  and  the  supposed 
limitations  of  the  joint-stock  company  during  this  period  may 
be  glimpsed  by  reference  to  a  well-known  quotation  from  Adam 
Smith: 

The  only  trades  which  it  seems  possible  for  a  joint-stock  com- 
pany to  carry  on  successfully  without  an  exclusive  privilege  are  those 
of  which  all  the  operations  are  capable  of  being  reduced  to  what  is 

called  routine Of  this  kind  is,  first,  the  banking  trade; 

secondly,  the  trade  of  insurance  in  fire  and  from  sea  risks  and  capture 
in  time  of  war;  thirdly,  the  trade  of  making  and  maintaining  a  navi- 
gable cut  or  canal;  and  fourthly,  the  similar  trade  of  bringing  water 
for  the  supply  of  a  great  city. 

He  adds  that  in  order  to  render  the  use  of  the  joint-stock  com- 
pany feasible,  two  other  circumstances  should  concur:  "first, 
that  the  undertaking  is  of  greater  and  more  general  utility 
than  the  greater  part  of  the  common  trades;  and  secondly, 
that  it  requires  a  greater  capital  than  can  easily  be  collected 
into  a  private  copartnership."  It  appears  that  the  corporation 
was  not  regarded  as  particularly  well  adapted  to  the  efficient 
conduct  of  most  lines  of  business,  but  that  it  was  a  very  useful 
device  in  lines  of  activity  where  it  was  necessary  to  raise  large 
sums  of  capital. 

The  third  stage  in  corporate  history  may  be  designated  the 
transportation  period,  beginning  in  England  about  1780. 
Adam  Smith,  who  wrote  in  1700.  had  foreseen  the  use  of  the 


THE  CORPORATION  AND  THE  RAISING  OF  CAPITAL       147 

corporation  in  connection  with  canal  building,  although  the 
great  era  of  canal  transportation  came  after  his  time — ^from 
1780  to  1815.  The  corporation  was  almost  universally  used 
as  a  means  of  assembhng  the  large  capital  required  for  canal 
construction.  It  is  significant  from  the  point  of  view  of  the 
capital-raising  function  of  corporations,  to  note  that  the  canal 
companies  did  not  conduct  transportation;  the  canal  barges 
were  run  by  individual  boatmen.  The  use  of  the  corporation 
was  here  dictated  solely  by  capital-raising  requirements.  This 
was  also  true  of  the  turnpike  companies. 

With  the  development  of  railway  transportation  after  1830 
the  use  of  the  corporation  was  greatly  extended.  While  in  the 
case  of  the  railroads  the  corporation  was  early  used  both  as  a 
capital-raising  and  as  an  operating  device,  the  capital-raising 
feature  was  of  primary  importance.  It  was  manifestly  impos- 
sible to  raise  the  funds  required  by  individual  or  partnership 
means.  As  with  the  old  trading  companies,  not  only  was  the 
volume  of  capital  required  very  large,  but  the  risks  assumed 
were  likewise  exceptional. 

The  fourth  stage  is  that  of  the  extension  of  the  corporate 
form  of  organization  to  producing,  manufacturing,  and  mer- 
cantile enterprises.  Although  the  corporation  was  used  to 
some  extent  in  ordinary  business  in  both  England  and  the 
United  States  before  1800,  it  was  not  until  after  the  develop- 
ment of  efficient  and  cheap  transportation  systems  that  it 
became  the  dominant  form  of  organization  in  manufacturing 
and  mercantile  lines.  During  the  earher  years  of  its  history 
the  factory  system  did  not  require  very  large  aggregations  of 
capital,  for  the  simple  reason  that  markets  were  narrowly 
circumscribed,  owing  to  the  inadequacy  and  the  great  cost  of 
transportation,  as  also  to  the  decentralization  of  wealth  and 
population.  The  volume  of  output  that  could  be  sold  by  any 
single  plant  was  thus  definitely  limited.  Under  these  conditions 
only  a  few  thousands  of  dollars  of  capital  was  required  for  the 
largest  business  establishment;  individuals  and  partnerships 
found  no  serious  handicap  in  financing  such  enterprise.  But 
while  the  earlv  factories  did  not  reauire  large  caoital.  in  view 


148         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

of  market  limitations,  their  development  gave  rise  to  an  in- 
sistent pressure  for  wider  markets,  in  order  to  make  possible 
a  larger  and  more  profitable  scale  of  industrial  enterprise; 
and  this  undoubtedly  hastened  the  development  of  efficient 
transportation. 

The  widening  of  markets  that  resulted  from  the  development 
of  modern  transportation  facilities  gave  in  turn  a  tremendous 
impetus  to  the  enlargement  of  the  size  of  business  undertakings. 
Given  cheap  transportation  to  the  markets  of  the  world,  there 
was  almost  no  limit  to  the  profitable  size  of  the  business  unit. 
By  1845  railroad  transportation  had  definitely  proved  itself, 
both  in  England  and  in  the  United  States;  and  before  i860  it 
had  succeeded  in  linking  the  great  Middle  West  with  all  the 
markets  of  the  world. 

The  second  half  of  the  nineteenth  century  then  witnessed 
a  gigantic  effort  on  the  part  of  industries  to  expand  the  scale 
of  their  productive  operations  to  a  point  where  they  could  take 
full  advantage  of  the  world-markets  that  were  available  to 
them.  Cheap  transportation  meant  reduced  costs  for  the  lay- 
ing down  of  goods  in  distant  markets.  And  the  enlarged 
output  made  possible  by  widened  markets  still  further  reduced 
the  cost  per  unit  and  made  possible  a  competition  over  ever- 
widening  areas.  This  tremendous  growth  in  the  size  of  the 
producing  unit,  and  also  in  the  size  of  the  commercial  and 
distributing  businesses  concerned  with  the  marketing  process, 
made  the  use  of  the  corporation  as  a  capital-raising  device  just 
as  indispensable  here  as  it  was  in  foreign  trading,  finance, 
insurance,  and  transportation.  Where  during  its  earlier  history 
the  factory  required  a  capital  of  perhaps  a  few  thousand  dollars, 
the  large-scale  business  enterprises  of  the  present  necessitate 
capital  accumulations  of  hundred  of  thousands,  millions,  and 
even  hundreds  of  millions  of  dollars. 

Thus  did  the  changing  structure  of  industrial  society, 
with  its  ever-increasing  size  of  business  undertaking  and  ever- 
enlarging  capital  requirements,  gradually  extend  the  scope 
of  corporate  industry,  until  today  the  corporation  is  the  domi- 


THE  CORPORATION  AND  THE  RAISING  OF  CAPITAL     149 

nant  form  of  business  organization.  Without  minimizing  the 
advantages  of  the  corporation  as  an  operating  agency,  it  may 
be  repeated  that  intrinsically  and  historically  the  corpora- 
tion is  a  capital-raising  device.  We  shall  see  in  the  following 
and  in  other  chapters  that  this  changing  industrial  structure, 
with  the  development  of  the  corporation,  has  called  into 
existence  most  of  the  financial  institutions  that  function  in  the 
economic  system  of  today,  and  has  profoundly  modified  the 
problems  of  organization  and  control  of  all  of  them. 


QUESTIONS  FOR  DISCUSSION 

1.  Is  the  corporation  to  be  regarded  primarily  as  an  efficient  form 
of  organization  for  the  conduct  of  a  business  once  established, 
or  primarily  as  an  efficient  instrument  for  raising  capital  ?  Is  it 
either  excliisively  ? 

2.  What  advantages  do  shares  of  stock  and  bonds  afford  as  a  means 
of  raising  capital  ? 

3.  Why  should  both  bonds  and  stock  have  been  developed? 

4.  What  is  the  purpose  of  issuing  different  kinds  of  stock  and 
bonds  ? 

5.  Without  bonds  and  stock  it  would  be  impossible  for  an  individual 
of  moderate  means  to  diversify  his  investments.  Why?  Indi- 
cate the  probable  results  of  such  a  situation. 

6.  In  what  way,  precisely,  is  the  ready  transferability  of  bonds  and 
shares  an  inducement  to  investment? 

7.  What  would  people  do  with  temporarily  idle  funds  in  the  absence 
of  an  opportunity  to  invest  in  readUy  marketable  securities  ? 

8.  Indicate  how  the  perpetual  existence  of  a  corporation  might 
facilitate  the  raising  of  capital. 

9.  What  is  the  significance  of  the  Hmited  liability  principle  from  the 
viewpoint  of  capital  raising  ?  Has  it  any  significance  from  any 
other  point  of  view  ? 

10.  What  opportunities  for  investment  existed  in  England  before 
the  extensive  development  of  the  joint-stock  company  ? 

1 1 .  Have  we  had  speculative  manias  since  the  time  of  which  Macaulay 
wrote  ?  (See  pp.  186-87  below.)  Do  plenty  of  opportunities  for 
conservative  investment  alwajrs  deter  people  from  indulging  in 
speculation  ? 


15©        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

12.  During  that  period  of  English  history  when  corporations  were 
not  granted  the  limited  liability  principle,  did  they  possess 
any  advantage  over  partnerships  in  the  raising  of  capital  ?  Were 
they  subject  to  any  comparative  disadvantages  ? 

13.  Why  was  it  so  difficult  to  enforce  the  Bubble  Act  in  England  ? 

14.  How  do  you  account  for  the  hostility  to  the  principle  of  Umited 
liability  that  was  manifest  in  England  imtil  the  middle  of  the 
nineteenth  century  ? 

15.  Suggest  some  of  the  probable  industrial  consequences  of  the 
refusal  to  permit  limited  liability  in  England  between  1825  and 
1856.  What  were  the  outstanding  industrial  requirements  of 
this  period  ? 

16.  Do  you  know  of  any  classes  of  corporations  today  whose  liability 
is  not  limited  to  the  individual  shareholders'  contributions  ? 

17.  Outline  the  different  stages  in  corporate  development  and  indi- 
cate why  each  new  stage  developed. 

18.  Has  Adam  Smith's  prophecy  come  true?  What  did  he  over- 
look? 

19.  Are  there  any  great  divisions  of  economic  activity  that  are  not 
at  the  present  time  characteristically  organized  on  the  corporate 
basis  ?  If  so,  what  ?  Is  this  likely  to  be  a  permanent  state  of 
affairs? 


CHAPTER  XII 

CREDIT  INSTRUMENTS 

The  borrowing  or  credit  operations  of  modern  society  are 
evidenced  by  written  documents,  drawn  up  in  legal  form,  and 
known  as  credit  instruments.  As  has  already  been  noted,  the 
term  "credit"  is  often  loosely  employed  in  such  a  way  as  to 
give  the  impression  that  credit  is  a  form  of  currency.  It  is 
not  credit,  however,  that  is  used  as  a  form  of  currency;  it  is 
rather  the  instruments  which  are  the  written  evidences  of 
antecedent  credit  operations  that  serve  as  media  of  exchange. 
In  the  present  chapter  we  shall  consider  the  various  types  of 
credit  instruments  which  are  employed  in  modem  credit  opera- 
tions and  discuss  the  development  of  certain  legal  principles 
which  have  made  possible  the  effective  use  of  these  instruments 
in  transferring  the  ownership  of  wealth. 

As  is  indicated  in  the  diagrams  on  pages  134  and  136,  the 
capital  of  modern  businesses  is  usually  divided  into  two  classes, 
fixed  and  working.  The  financial  instruments  that  are  used  in 
evidencing  the  loans  made  in  the  raising  of  fixed  capital  are 
usually  called  investment  credit  instruments;  while  those 
evidencing  borrowed  working  capital  are  known  as  commercial 
credit  instruments.  Let  us  consider  the  various  t3^s  of 
instruments  that  fall  within  each  class. 

I.    INVESTMENT  CREDIT  INSTRUMENTS 

The  three  principal  types  of  investment  credit  instruments 
are  bonds,  stock  certificates,  or  shares,  and  short-term  notes. 
An  explanation  is  perhaps  necessary  for  designating  a  share  of 
stock  as  a  credit  instrument;  for  from  a  certain  point  of  view  a 
shareholder  is  legally  not  a  creditor  of  the  corporation  but  a 
joint  owner  in  the  enterprise.  He  receives  income  from  his 
shares  only  in  case  the  earnings  are  sufficient  to  permit  or 
warrant  the  payment  of  dividends.    Th^  bondholder,  op  thQ 


IS2         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

other  hand,  is  legally  a  creditor  of  the  corporation  and  is 
entitled  to  interest  on  his  investment,  regardless  of  the  volume 
of  earnings. 

Although  the  stockholder  is  legally  not  a  lender  of  funds  to 
the  corporation,  but  a  part  owner  in  the  enterprise,  he  is  never- 
theless for  all  practical  purposes  commonly  an  "outsider" 
lending  his  funds  in  anticipation  of  a  return.  The  rank  and  file 
of  investors  in  stocks  are  not  in  fact  actively  interested  in  the 
management  of  the  concern.  Indeed,  it  is  a  rare  thing  for  any 
but  a  relatively  small  group  of  insiders  to  exercise  their  voting 
prerogatives.  The  familiar  expression,  "Shall  I  invest  in 
stocks  or  bonds?"  indicates  clearly  enough  that  in  a  majority 
of  instances  the  purchaser  makes  no  differentiation  between 
stock  and  bonds,  save  as  to  relative  certainty  of  income. 

A  mortgage  security  does  not  guarantee  against  loss.  The 
fact  that  a  bond  is  usually  secured  by  a  mortgage  on  the  property 
does  not  insure  that  the  bondholder  cannot  lose  on  his  invest- 
ment. In  the  event  that  earnings  are  not  sufficient  to  pay 
interest  on  bonds,  the  bondholder  may  foreclose  under  the 
terms  of  the  mortgage  and  take  possession  of  the  property; 
but  an  enterprise  whose  earnings  are  insufficient  to  permit 
the  payment  of  interest  on  its  bonds  could  not  ordinarily  be 
sold  at  a  price  which  would  equal  the  amount  of  the  bond- 
holder's investment — whatever  may  have  been  the  evaluation 
originally  placed  upon  the  property.  Nor  is  there  any  assur- 
ance that  the  bondholders  can  conduct  such  an  enterprise 
at  a  profit;  indeed,  there  is  a  certainty  that  they  cannot  do  so 
when  the  mortgage  is  against  only  a  portion  of  the  corporation's 
property.  In  the  event  that  interest  on  bonds  is  not  paid,  it 
is  therefore  usually  wise  to  effect  a  financial  reorganization,  by 
means  of  which  the  amount  of  outstanding  bonds  is  reduced 
by  converting  some  of  the  bonds  into  stock.  It  is  thus  apparent 
Ihat  in  the  last  analysis  the  safety  of  both  bonds  and  stock 
depends  upon  the  earning  power  of  the  corporation.  It  remains 
true,  however,  that  bonds  are  usually  the  more  conservative 
investment  by  virtue  of  their  prior  claim  to  earnings.* 

The  fact  that  bonds  have  a  maturity  date  is  also  often  of  practical 
importance. 


CREDIT  INSTRUMENTS  153 

There  are  various  types  of  stocks.  Shares  of  stock  axe  / 
divided  into  two  main  classes,  preferred  and  common.  As  tn\y 
term  itself  indicates,  preferre3"'stock  has  a  prior  claim  on 
dividends  and  usually  in  the  event  of  liquidation  on  the  assets 
of  the  business.  Because  of  the  existence  of  common  stock 
as  a  participant  in  the  earnings  of  the  corporation,  it  is  obviously 
necessary  to  limit  the  extent  to  which  preferred  shares  may 
receive  dividends.     Seven  per  cent  is  the  usual  limit. 

Preferred  stock  may  be  either  cumulative  or  non-cumulative, 
participating  or  non-participating.  With  cumulative  stock 
the  dividends  which  cannot  be  paid  in  one  year,  because  of  low 
earnings,  accumulate  from  year  to  year  as  an  obligation  prior 
to  that  on  common  stock.  With  participating  preferred  stock 
the  owner  is  entitled  to  share  in  the  earnings  above  the 
7  per  cent  limit;  sometimes  it  is  an  equal  participation  in  all 
earnings  above  7  per  cent  on  the  common  stock,  and  some- 
times it  is  above  10  or  above  15  per  cent,  depending  upon 
the  specific  terms  governing  the  issue.  The  great  number  and 
variety  of  corporations  that  exist  have  given  rise  to  other 
variations  on  these  practices,  a  detailed  study  of  which  is  quite 
unnecessary  for  the  present  purpose. 

Some  modern  preferred  stocks  are  almost  equal  to  bonds.  In 
recent  years  preferred  stock  has  developed  some  additional 
features  which  now  place  it  more  nearly  on  an  equality  with 
bonds  in  the  matter  of  certainty  of  income.  Provisions  such 
as  the  following  are  common  to  what  is  called  "  modern  preferred 
stock." 

1.  No  bonded  debt  exists  nor  can  any  be  created  without  the 
consent  of  75  per  cent  of  the  preferred  stockholders.  No  stock  having 
priority  over,  or  on  a  parity  with,  this  issue  exists  nor  can  be  created 
without  the  same  consent. 

2.  A  cumulative  sinking  fund  of  5  per  cent  per  annum  of  the 
greatest  amount  of  preferred  stock  at  any  time  outstanding  is 
created  for  retiring  the  issue  at  not  more  than  no.  This  increases 
the  equity  in  the  property  annually  and  assists  in  maintaining  the 
market  price. 

3.  Net  total  assets  must  be  maintained  at  250  per  cent  and  net 
Quick  assets  at  150  per  cent  of  the  preferred  stock  outstanding. 


154         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

4,  No  dividends  can  be  paid  on  the  common  stock  until  a  reserve 
equal  to  two  years'  dividend  and  sinking  fund  requirements  on  the 
preferred  stock  has  been  set  up  out  of  earnings,  and  none  can  be  paid 
which  will  impair  this  reserve. 

With  these  provisions  in  force  the  preferred-stock  owner 
is  in  a  position,  from  the  standpoint  of  security,  almost  equal 
to  that  of  the  bondholder.  It  remains  true,  however,  that  in 
case  dividends  are  not  paid,  the  individual  shareholder  has  no 
power  to  take  possession  of  the  management  of  the  corporation, 
as  has  a  bondholder  under  the  terms  of  the  usual  mortgage. 

The  common  stock  of  the  corporation  merely  represents 
claims  to  such  earnings  as  may  be  available  after  the  payment 
of  dividends  on  preferred  stock.  Dividends  on  common  stock 
will  accordingly  vary  widely  in  amount,  depending  on  the 
volume  of  the  earnings.  Since  common  stock  is  traditionally 
speculative  and  uncertain  as  to  dividends,  the  majority  of 
corporations  do  not  hesitate  to  "pass"  common-stock  dividends 
as  a  matter  of  financial  conservatism,  even  though  the  earnings 
might  be  frequently  sufficient  to  pay  a  moderate-sized  return. 

Stock  is  now  being  issued  without  any  par  value.  Stock, 
both  preferred  and  common,  has  usually  been  issued  with  a  par 
value,  most  commonly  of  $100,  although  often  of  $50,  $25,  $10, 
$5,  and  $1;  it  has  even  been  as  low  as  5  cents  in  the  case  of 
highly  speculative  issues.  During  recent  years,  however, 
numerous  corporations  have  issued  stock  without  any  par 
value.  In  the  year  1919,  for  instance,  twenty-seven  stocks  of 
no  par  value  were  listed  on  the  New  York  Stock  Exchange. 
When  stock  is  issued  without  par  value,  a  certain  total  number 
of  shares  is  offered  for  sale  and  each  will  bring  in  the  market  a 
price  that  is  determined  by  the  estimated  earning  power  of  the 
corporation.  Dividends  on  such  stock  are  paid,  not  as  so  many 
per  cent  on  $100  par  value,  but  as  so  many  dollars  per  share. 
Stock  without  any  par  value  is  of  advantage  in  that  it  is  not 
so  likely  to  mislead  the  innocent  investor,  who  somehow  will 
persist  in  believing  that  a  stock  whose  par  value  is  $100  will 
ultimately  be  worth  $100,  even  though  its  temporary  market 
price  may  be  below  that  figure;  hence  he  will  pay  for  it  more 


CREDIT  INSTRUMENTS  155 

than  its  real  worth.  From  the  viewpoint  of  the  corporation 
the  issue  of  stock  without  par  value  is  also  a  means  whereby 
opposition  to  overcapitalization  may  in  a  measure  be  circum- 
vented. 

Stockholders^  ^'rights"  are  an  interesting  but  little  known 
form  of  credit  instrument.  Stockholders'  "rights"  have  arisen 
out  of  the  exigencies  of  corporate  financing.  For  instance, 
when  the  existing  stock  of  a  corporation  is  selling  at,  say,  105, 
additional  capital  can  easily  be  raised  by  offering  for  sale  new 
shares  at  par,  or  slightly  above.  But  if  additional  shares  are  to 
be  offered  for  sale  at  a  bargain,  it  is  only  equitable  that  the 
existing  stockholders  should  be  given  the  first  chance  to  sub- 
scribe for  the  new  issue,  because  the  increased  capitalization 
may  well  affect  the  value  of  outstanding  shares.  Accordingly, 
it  is  the  usual  practice  to  allow  existing  shareholders  to  subscribe 
for  the  new  issue  in  proportion  to  the  amount  of  their  holdings; 
indeed,  in  many  jurisdictions  the  stockholders  have  a  legal 
right  to  subscribe  for  new  stock  at  par. 

Such  stockholders'  privileges  are  known  as  "rights," 
and  they  are  issued  to  shareholders  in  the  form  of  transferable 
instruments.  Upon  the  receipt  of  one  of  these  instruments, 
the  shareholder  may  either  avail  himself  of  the  opportunity 
to  purchase  stock  at  par,  or  whatever  the  figure  mentioned, 
or  he  may  sell  his  right  to  another.  These  rights  are  in  fact 
bought  and  sold  on  the  stock  exchanges  in  the  same  manner  as 
bonds  and  shares.  The  market  value  of  a  shareholder's  right 
is  roughly  equal  to  the  estimated  difference  between  the  issue 
price  of  the  new  stock  of  the  corporation  and  its  prospective 
market  price. 

There  are  many  different  types  of  bonds.  The  terminology 
employed  in  describing  the  many  different  types  of  bonds  that 
are  in  use  nowadays  is  quite  baffling  to  the  layman.  For 
instance,  a  certain  bond  is  described  as  follows:  a  5  per  cent 
railroad  collateral  trust,  refunding,  registered,  coupon  gold 
bond.  The  whole  matter  may  be  greatly  simplified  by  classify- 
ing bonds  from  certain  points  of  view  as  follows:  (i)  the 
nature  of  the  issuing  corporation;  (2)  the  purpose  of  the  issue; 


IS6  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

(3)  the  conditions  governing  the  payment  of  interest  or  princi- 
pal; and  (4)  the  character  of  the  security. 

The  most  important  sub-classes^  under  each  of  these  head- 
ings are  as  follows: 

1.  The  nature  of  the  issuing  corporation 

a)  Gk)vernment  bonds — national,  state,  territorial,  county, 
city,  township,  school  district,  etc. 

b)  Corporation  bonds — transportation,  pubUc  utility,  indus- 
trial, reclamation,  real  estate,  timber,  etc. 

2.  The  purpose  of  the  issue 

a)  Construction  bonds  c)  Refunding  bonds 

b)  Improvement  bonds  d)  Equipment  bonds 

3.  The  conditions  governing  thie  payment  of  interest  or 
principal.  (Classification  here  is  dependent  upon  the  legal 
provisions  governing  payment  of  principal  and  interest.) 

a)  Participating  bonds  e)  Premium  bonds 

b)  Profit-sharing  bonds  /)  Serial  bonds 

c)  Registered  coupon  bonds        g)  Callable  bonds 

(i)  Gold  bonds  h)  Convertible  bonds 

4.  The  character  of  the  security 

a)  First  mortgage  c)  Collateral  trust 

b)  Second  mortgage  d)  Debenture 

In  the  case  of  a  first-mortgage  bond  the  bondholders  have  a 
prior  claim  against  income,  and  against  property  in  case  interest 
on  the  bonds  is  not  paid.  The  mortgage  pledges  the  property 
owned  by  the  corporation  as  a  security  for  the  payment  of 
interest  and  principal.  Since  it  is  obviously  impossible  to  give 
each  bondholder  a  share  of  the  mortgage,  the  mortgage  is  piaced 
in  trust,  and  in  the  event  of  failure  to  pay  interest  the  bond- 
holders as  a  group  may  foreclose  under  the  terms  of  the  agree- 
ment and  take  possession  of  the  property. 

As  the  name  indicates,  a  second  mortgage  constitutes  a 
secondary  claim  against  income  and  property.     Anything  left 

•  Only  the  main  subdivisions  in  each  case  are  given.  For  a  full  classi- 
fication the  reader  is  referred  to  Lawrence  Chamberlain,  The  Principles  of 
Bond  Investment  (Henry  Holt  &  Co.),  chaps,  viii  to  xi,  inclusive.  The 
kind  of  individual  securities  that  might  be  listed  under  the  various  sub- 
classes are  legion. 


CREDIT  INSTRUMENTS  IS7 

after  payments  have  been  made  to  the  owners  of  the  first 
mortgage  may  be  devoted  to  meeting  the  clauns  of  the  second- 
mortgage  holders. 

A  collateral  trust  bond  is  one  which  is  secured,  not  by  real 
estate  or  other  physical  property  owned  by  the  corporation, 
but  by  stock  or  bonds  of  other  companies  owned  by  the  issuing 
corporation.  This  type  of  security  is  mainly  found  in  connec- 
tion with  railroad  companies.  The  term  "trust"  indicates  that 
these  collateral  securities  are  placed  in  trust  with  a  trust  company 
or  other  trustee.  In  the  event  interest  is  not  paid  on  such  bonds, 
the  holder  may  seize  the  collateral  which  is  held  in  trust. 

A  debenture  bond  proper  has  no  mortgage  security  but 
merely  a  claim  against  the  income  of  the  corporation — a  claim, 
moreover,  that  is  secondary  to  that  of  any  outstanding  mortgage 
bonds.  Its  claim  against  net  earnings,  however,  is  prior  to 
that  of  preferred  stock. 

The  short-term  note  is  now  frequently  employed  in  raising 
fixed  capital.  The  designation  "short  term"  is  employed  be- 
cause the  notes  in  question  usually  run  from  one  to  five  years 
rather  than  for  long  periods,  as  is  the  case  with  bonds.  These 
notes  are  usually  secured  only  by  the  income  of  the  company. 
Accordingly  it  is  customary  for  payments  on  the  principal  to 
be  made  serially,  that  is,  a  certain  percentage  of  the  total  debt 
is  paid  back  annually,  thus  gradually  increasing  the  security 
back  of  the  loan. 

Short-term  notes  are  usually  issued  to  meet  temporary 
emergencies.  In  periods  of  tight  money  and  high  interest 
rates,  or  of  general  uncertainty  over  the  industrial  future,  it 
is  difficult  to  sell  long-time  bonds  on  favorable  terms;  hence 
it  has  been  found  expedient  to  sell  short-term  notes  which  can 
be  refunded  into  long-term  bonds  at  a  more  propitious  time. 
Short-term  notes  are  also  used — ^and  increasingly  so — to  provide 
funds  for  new  construction  under  conditions  such  that  the  debt 
can  be  paid  off  out  of  earnings  within  a  relatively  short  period 
of  time.    Their  claim  on  income  is  secondary  to  that  of  bonds. 

The  accompanying  illustrations  are  examples  of  a  standard 
bond  and  a  share  of  stock. 


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l62         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

n.    COMMERCIAL  CREDIT  INSTRUMENTS 

Commercial  credit  instruments — ^promissory  notes  and  bills 
of  exchange — are  the  written  evidences  of  the  commercial  bor- 
rowing operations  discussed  in  the  preceding  chapter.  Because 
of  the  nature  of  the  uses  to  which  funds  borrowed  for  working- 
capital  purposes  are  devoted,  these  instruments  run  for  short 
periods  of  time  only.  Especial  importance  is  attached  to 
them  because  of  the  prevalent  use  of  certain  forms  of  bills  of 
exchange  as  a  substitute  for  money,  a  phenomenon  made 
possible,  as  we  shall  see,  by  the  principle  of  negotiabiUty. 

Book  accounts.  Many  credit  operations  are  evidenced 
merely  by  entries  in  the  accoimt  books  of  business  men — 
"accounts  receivable"  in  the  books  of  the  seller  (or  lender),  and 
"accounts  payable"  in  the  books  of  the  buyer  (or  borrower). 
While  such  informal  credit  extension  is  quite  as  significant  as 
any  other,  it  does  not  concern  us  here  for  the  reason  that  it  does 
not  give  rise  to  tangible  legal  instruments. 

The  promissory  note.  A  promissory  note  is  an  unconditional 
written  promise  by  X,  the  maker,  to  pay  at  a  definite  future 
date  a  sum  of  money  to  Y,  the  payee.  It  may  or  may  not 
designate  the  place  at  which  payment  is  to  be  made.  Promis- 
sory notes  may  be  issued  by  banking  and  other  institutions  and 
governments  as  well  as  by  individuals,  and  as  a  result  of  non- 
commercial as  well  as  of  commercial  obligations.  An  illustration 
of  a  promissory  note  will  be  found  on  page  163  below. 

The  draft  or  bill  of  exchange.  A  bill  of  exchange,  or  draft, 
is  an  unconditional  written  order  signed  by  X  (the  drawer) 
ordering  Y  (the  drawee)  to  pay  at  a  definite  date  a  definite  sum 
of  money  to  Z  (the  payee).  The  payee  may  be  the  same  p)erson 
as  the  drawer.  Before  a  time  draft  is  good,  the  drawee  must 
indicate  his  willingness  to  honor  it  by  signing  his  name  below 
the  word  "Accepted"  written  across  the  face  of  the  bill. 

Bills  of  exchange  may  be  classified  from  several  points  of 
view.  In  the  first  place,  we  have  (i)  foreign  and  (2)  domestic,  or 
inland,  bills.  A  foreign  bill  is  legally  defined  as  one,  the  drawer 
and  drawee  of  which  live  in  different  countries  or  different 
states  of  the  United  States;  while  a  domestic  bill  is  one,  both 


CREDIT  INSTRUMENTS  163 

parties  to  which  live  within  the  same  state.  This  classification 
is  of  importance  from  the  legal  point  of  view,  but  from  the 
standpoint  of  commercial  and  banking  practice  the  distinction 
is  without  significance. 

We  have  thus  fa;r  been  using  the  terms  "bill  of  exchange" 
and  "draft"  indiscriminately.  The  two  terms  are,  in  fact,  com- 
monly used  interchangeably;  for  instance,  we  speak  of  drafts 
on  London  and  bills  of  exchange  on  London,  and  we  say  New 
York  exchange  or  drafts  on  New  York.  The  term  "draft," 
however,  is  by  many  people  employed  when  they  mean  a  par- 
ticular type  of  draft,  such  as  a  banker's  draft  or  a  draft  drawn 

PROMISSORY  NOTE 


(-Y^ -jri-^-y      '^-'*-^*lt    -  after  data  for  value  received  the  undersigned  prtanlse  to  pay  to  the  ontsr  )d 

^        "1>)E  National  City  Bank  of  Chicago 

<~r^^^^-%.,^^.„^c/yt^^.  <?-.-<  j/^  ^n, r:^rr=;^:Trrr==r=m__  DOLLARS 

at  its  Banking  House  in  Chicago  Illinois,  with  interest  AFTER  MATURITY  at  the  rate  of  seven  per  cent  per 
annum  until  paid  and  with  costs  of  collection  and  a  reasonable  attorney  fee  if  not  paid  at  maturity.  Presentment 
and  demand  for  payment,  notice  of  non-payment,  protest  and  notice  of  protest  are  each  and  all  hereby  wahed  by 
the  makers,  endorsers  and  guarantors  jointly  and  severally.  Any  indebtedness  owing  from  said  bank  or  legal 
holder  hereof  to  the  undersigned  or  to  any  endorser  or  guarantor  mag  be  appropriated  and  applied  l>y  said  bank 
or  legal  holder  on  this  note  at  any  time  either  Ixfore  or  after  maturity  of  this  note  and  without  demand  upon  or 
notice  to  any  one. 


BUSINESS  AOORESBi 


;^^^ 


■iX^*-^  O^yt/2^  ^C/>t-<^<^-.a— ■.-^^^/[^^K' 


by  one  individual  on  another  as  a  reminder  that  a  debt  is  due 
and  payable.  Li  order  to  give  precision  to  our  terminology 
it  will  be  well  for  us  to  use  the  term  "draft" — ^and  this  appears 
to  be  a  growing  custom — when  speaking  of  domestic  operations, 
whether  or  not  they  cross  state  lines;  and  the  term  "bill  of 
exchange"  when  speaking  of  international  credit  instruments. 

These  instruments  may  also  be  classified  according  to 
whether  the  parties  to  the  order  are  bankers.  A  banker's  draft 
is  an  order  drawn  by  one  bank  on  another  bank,  although  it  is 
not  necessary  that  the  party  to  whom  it  is  payable  be  a  bank. 
A  bill  drawn  by  one  individual  against  another  would  be  called, 
an  individual  draft. 

Finally,  bills  may  be  classified  in  accordance  with  the  nature 
pf  the  operation  giving  rise  to  the  draft.    Hence  we  have 


i64         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

bankers'  or  finance  bills,  trade  or  commercial  bills,  and  accom- 
modation bills.  Bankers'  bills  are  used  merely  as  a  means  of 
making  payments  and  transferring  balances  between  banks. 
A  trade  draft,  or  a  "trade  acceptance,"  to  use  the  more  common 
term,  is  an  order  drawn  by  a  seller  of  gqods  against  the  buyer 
of  the  goods  and  accepted  by  the  latter.  Accommodation 
drafts  are  drafts  which  do  not  arise  out  of  any  business  trans- 
action already  concluded;  and  there  may  or  may  not  be  an 
intention  to  purchase  goods  with  the  funds  procured;  it  is  a 
" non-trade "  draft.  "Accommodation "  is  a  term  that  has  been 
handed  down  from  English  commercial  practice  and  is  not  fre- 
quently employed  in  the  United  States  at  the  present  tune. 

The  accompanying  forms  on  pages  165,  166,  and  167,  are 
specimens  of  the  various  types  of  drafts. 

Checks,  bank  notes,  and  bank  drafts  are  not  really  credit  instru- 
ments. Bills  of  exchange  are  also  sometimes  classified  as  demand 
and  time  bills:  a  demand  bill  being  one  payable  "at  sight," 
that  is,  immediately  upon  presentation,  and  a  time  bill  one 
payable  at  some  definite  date  in  the  future.  It  is  these  demand 
instruments,  particularly  bank  notes,  cashiers'  checks,  bank 
drafts,  and  personal  checks  drawn  against  bank-deposit  ac- 
counts, that  serve  extensively  as  media  of  exchange.  While 
these  demand  notes  and  bills  have  commonly  been  called  credit 
instruments,  they  are  strictly  not  credit  instruments  at  all,  for 
they  are  not  evidences  of  postponed  payments,  the  essential 
characteristic  of  credit  operations.  A  few  words  of  explanation 
will  serve  to  clarify  matters. 

A  check  is  a  credit  instrument  in  the  sense  that  it  must  be 
honored  by  the  bank  before  it  is  the  equivalent  of  cash,  just  as 
credit  b  involved  in  a  business  operation  when  one  receives 
goods  a  second  or  so  before  he  passes  the  money  over  to  the 
seller;  there  is  a  brief  interval  during  which  the  seller  is  waiting 
to  be  paid.  But  no  one  really  regards  such  a  business  trans- 
action as  a  credit  operation,  the  essence  of  which  is  a  postponed 
or  future  payment.  A  cashier's  check,  a  certified  check,  and 
even  an  uncertified  check  in  the  vast  majority  of  instances  are 
in  practice  precisely   as   satisfactory   means  of  payment  as 


CREDIT  INSTRUMENTS 


i6S 


l66         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


n 


CREDIT  INSTRUMENTS 
banker's  bill  of  exchange  on  LONDON 


167 


EXCHANGE  FOR 


>.. 


-^. 


''?^£t'x?/^^  FIRST  OF  EXCHANGE 


^^. 


!:i««» 


,Q^gg-»,^^ 


7^ 


SNATIONALBANK£NaRTHAMEItlCA,CHICASO 


Z^ 


r^Lt-x^  c&rly 


CASmER's  CHECK 


.  Wl  UM   ^J  »u.  ■■  -.  mr- 


M 


:STATK   or  II.MNCIISj 


^^kt  TnEXvnoxviiCmRvxiiOFGiiiCAGO 


^^f^s±p^-^l  „^^u...^ 


No.  «?  ^^ 


^Tg.^ 


PERSONAL  BANK  CHECK 


ChicagoJll- 


PAY  TO  THE  ORDER  OF. 


>^^=*^*^?g^^-^ 


TheRroStNationalBankof  Englewood2 109 


JLADIES  DEPARTMENT. 


DOi-LAHS 


i68         THE  FESTANCIAL  ORGANIZATION  OF  SOCIETY 

actual  cash.  Even  though  they  are  credit  instruments  in  form 
— mere  promises,  direct  or  implied,  to  pay  cash — this  distinc- 
tion has  Uttle  practical  significance.  For  the  same  reason  the 
bank  note,  which  is  a  promise  by  a  bank  to  pay  to  the  borrower 
on  demand  a  certain  specified  sum  of  money,  is  not  a  credit 
instrument;  it  passes  everywhere  as  an  equivalent  of  money. 

Checks,  bank  drafts,  and  bank  notes  are  credit  instruments 
only  in  the  sense  that  greenbacks  and  token  coins  are  credit 
currency.  These  sight  instruments,  like  greenbacks  and  token 
coins,  are  not  backed  by  a  gold  reserve  of  loo  per  cent;  and 
hence  confidence  in  the  ability  of  the  banks  and  of  the  govern- 
ment to  redeem  them  upon  demand  is  an  essential  to  their 
acceptance  as  media  of  exchange.'  Under  ordinary  circum- 
stances no  one  questions  the  convertibility  of  these  instruments 
into  gold  on  demand,  and  accordingly  they  are  for  all  practical 
purposes  lequal  to  gold  as  a  means  of  payment.  Whenever  a 
doubt  arises  as  to  the  possibility  of  conversion,  as  it  has  arisen 
in  the  past,  the  difiference  between  such  instruments  and 
standard  money  is  revealed.  But  this  does  not  make  them 
credit  instruments  in  the  same  sense  that  a  promise  to  pay  at 
some  future  date  is  a  credit  instrument. 

Notes  and  drafts  serve  identical  purposes.  It  remains  to 
point  out  the  similarity  of  the  operations  that  give  rise  to  promis- 
sory notes  and  bills  of  exchange.  Mr.  Jones,  a  wholesaler, 
sells  goods  on  credit  to  Mr.  Smith,  a  retailer.  The  transaction 
may  of  course  be  evidenced  merely  by  "open  accounts"  on  the 
books  of  Jones  and  Smith,  respectively — "accounts  receivable" 
from  Smith  in  Jones's  books,  and  "accounts  payable"  to  Jones 
in  Smith's  books.  But,  passing  by  this  informal  method  of 
evidencing  the  credit  operation,  the  sale  of  goods  by  Jones 
to  Smith  may  give  rise  either  to  a  promissory  note  or  to  a  trade 
draft,  according  to  the  commercial  practice  in  vogue.  In  the 
case  of  a  promissory  note,  Mr.  Smith  takes  the  initiative  and 
writes  the  instrument  evidencing  his  obligation  to  pay  Jones. 

» An  uncertified  check  and  a  bank  draft  differ  slightly,  however,  from 
certified  and  cashiers'  checks  and  bank  notes  in  that  there  must  also  be 
confidence  that  the  drawer  has  the  requisite  fimds  to  his  credit  in  the  bank 
on  which  the  instrument  is  drawn. 


CREDIT  INSTRUMENTS  169 

In  the  case  of  the  trade  draft,  Jones  takes  the  initiative,  writes 
the  order  against  Smith,  and  sends  it  to  Smith,  who  honors  the 
draft  by  writing  "accepted"  on  its  face.  The  result  is  the 
same  in  either  case:  Smith  has  signed  a  legal  instrument 
obligating  himself  to  pay  Jones.  It  is  the  custom  nowadays, 
as  the  illustration  on  page  165  shows,  to  have  stated  on  the 
face  of  the  trade  acceptance  that  the  obligation  to  pay  arose 
out  of  a  sale  of  goods  by  Jones  to  Smith.  While  this  is  not  the 
custom  with  the  promissory  note,  there  is  no  theoretical  reason 
why  a  trade  note  carrying  such  a  statement  on  its  face  should 
not  be  developed. 

In  case  Jones  wishes  to  borrow  from  a  bank  in  anticipation 
of  the  payment  of  the  obligation  by  Smith,  he  may  do  so  by  hav- 
ing a  bank  discount  either  Smith's  note  or  Smith's  acceptance. 
From  the  standpoint  of  the  bank,  the  security  is  identical  in 
both  cases.  With  the  note  the  bank  has  Smith's  promise  to 
pay  at  maturity  and  a  secondary  liability  on  the  part  of  Jones, 
as  indorser.  With  the  draft  the  bank  again  has  Smith's  promise 
to  pay,  by  virtue  of  his  acceptance  of  the  instrument,  and  it 
has  Jones's  secondary  liability,  as  maker  of  the  draft.  Which 
form  of  instrument  is  employed  at  any  time  depends  upon  the 
custom  of  manufacturers  and  merchants.  In  Europe  the  draft 
is  characteristically  employed.  In  the  United  States  both 
drafts  and  notes  were  in  common  use  before  the  Civil  War;  but 
because  of  the  risks  of  price  changes  during  the  period  of  green- 
back currency  (see  p.  26  above)  American  commercial  practict" 
was  gradually  transformed  to  the  system  of  selling  on  "open" 
or  book  account.  Except  in  a  few  special  Unes  credit  instru- 
ments came  to  be  employed  only  in  cases  where  the  creditor's 
standing  was  not  first  class,  as  when  an  account  was  not  paid 
at  maturity  and  a  note  was  given  in  "settlement."  Since  the 
passage  of  the  Federal  Reserve  banking  law  in  19 13  an  effort 
has  been  made  to  restore  the  extensive  use  of  credit  instruments, 
in  the  form  of  the  trade  acceptance.  As  yet,  however,  the  effort 
has  not  been  as  successful  as  was  hoped;  and  the  desirability 
of  making  the  change  is  still  a  debatable  issue/ 

'  See  pp.  384-85. 


lyo         THE  FINANCIAL  ORGANIZATION,  OF  SOCIETY 

III.    THE  USE  OF  CREDIT  INSTRUMENTS  IN 
TRANSFERRING  WEALTH 

A  share  of  stock  is  a  written  evidence  of  ownership — that  is, 
partial  ownership — of  a  designated  business.  The  possessor  of 
a  share  is  in  effect  a  joint  owner  of  certain  definite,  tangible 
wealth,  although  in  the  nature  of  the  case  he  is  debarred  from 
taking  possession  of  such  wealth  without  the  consent  of  other 
shareholders.  The  owner  of  a  bond  or  promissory  note  or 
accepted  draft  has  a  partial  claim  against  definite,  tangible 
wealth  that  is  owned  by  others.  Under  present  conditions, 
where  industry  is  primarily  organized  on  the  corporate  basis, 
and  where  capital,  both  fixed  and  working,  is  largely  borrowed, 
these  ownership  shares  and  creditor  claims  represent  a  very 
considerable  proportion  of  the  total  wealth  of  the  world, 

A  business,  the  capitalization  of  which  runs  into  millions 
of  dollars,  is  seldom  sold  outright.  Its  shares  and  bonds  con- 
stantly change  hands,  however,  and  there  is  an  ever-shifting 
body  of  shareholders  and  creditors.  Similarly,  the  evidences  of 
borrowed  working  capital  in  the  form  of  promissory  notes  and 
bills  of  exchange  are  continually  being  transferred  through  the 
process  of  purchase  and  sale.  Indeed,  a  large  corporation 
does  not  usually  even  know  who  its  creditors  are,  either  the 
owners  of  its  bonds  or  the  holders  of  its  notes  and  acceptances; 
it  merely  knows  that  a  certain  total  amount  of  claims  against  it 
are  "floating"  somewhere  in  the  investment  and  commercial 
markets. 

In  the  preceding  chapter  we  have  seen  that  the  market- 
ability of  bonds  and  shares  greatly  facilitated  the  raising  of 
capital.  A  ready  marketability  is  equally  important  with 
short-term  promissory  notes  and  bills  of  exchange.  The  essen- 
tial point  is  that  if  one  were  not  able  to  extricate  himself  from 
a  financial  relationship,  if  he  could  not  regain  command  of  his 
funds  at  will,  he  would  be  less  willing  to  make  loans  either  for 
fixed  or  working  capital  purposes.  We  shall  find  that,  by  virtue 
of  the  development  of  certain  legal  principles,  these  credit 
instruments  have  also  come  to  be  extensively  used  as  a  means' 
of  transferring  the  ownership  of  wealth. 


CREDIT  INSTRUMENTS  171 

SalabilUy  and  transferability.  Thr-ee  legal  principles  have 
been  developed  to  facilitate  the  use  of  credit  instruments  in 
transferring  the  ownership  of  wealth:  namely,  salability, 
transferability,  and  negotiability.  The  various  forms  of  credit 
instruments — bonds,  shares,  notes,  drafts,  checks,  certificates 
of  deposit,  etc. — possess  these  attributes  in  varying  degrees, 
and  it  appears  that,  consciously  or  unconsciously,  each  has  been 
given  the  particular  attributes  required  by  the  nature  of  the  use 
to  which  it  has  been  found  convenient  to  devote  it. 

On  the  matter  of  salability  a  word  of  explanation  will  be 
sufficient.  By  means  of  a  sale  an  individual  may  transfer  to 
another  all  of  his  ownership  rights  in  a  piece  of  property.  The 
law  of  sales  has  been  made  applicable  to  all  of  these  credit 
instruments;  and  an  owner  of  one  of  them  may  therefore 
always  transfer  to  another  at  least  the  same  amount  of  owner- 
ship of  the  instrument,  and  thus  of  the  property  which  the 
instrument  represents,  that  he  himself  possesses. 

While  salability  is  an  obvious  prerequisite  to  the  transfera- 
bility of  any  of  these  instruments,  it  does  not  fully  explain  the 
latter.  For  instance,  a  credit  instrmnent,  unlike  tangible  per- 
sonal property,  may  be  automatically  transferred  by  the  mere 
process  of  indorsement,  that  is,  by  writing  one's  name  on  the 
back  of  an  instrument  that  is  made  payable  to  him  or  to  his 
order;  or,  in  the  case  of  an  instrument  made  payable  to  bearer, 
it  may  be  transferable  merely  by  deHvery,  that  is,  by  passing 
it  on  to  another.  Similarly,  an  instrument  that  has  been 
indorsed  in  blank,  that  is,  by  the  owner's  writing  his  name  on 
the  back  of  it  without  designating  any  specific  payte,  is  also 
transferable  by  mere  delivery.  The  ease  with  which  these 
instruments  may  be  transferred  renders  their  use  as  a  means 
of  exchanging  the  ownership  of  wealth  much  more  general  than 
would  otherwise  be  the  case. 

But  transferability  may  involve  more  than  this.  For  even 
though  he  himself  has  no  title  at  all,  a  possessor  of  an  instru- 
ment that  is  payable  to  bearer  may  transfer  to  another  a  valid 
or  unimpeachable  title.  A  bearer  instrument  is  thus  for  all 
practical  purposes  equivalent  to  money.     But  this  borders  on 


t7a         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  principle  of  negotiability,  to  a  consideration  of  which  we 
may  now  turn. 

The  principle  of  negotiability.  A  negotiable  instrument 
possesses  the  attribute  of  salability,  and  its  title  is  transferable 
from  one  person  to  another,  either  by  indorsement  or  by  delivery. 
But  it  has  other  attributes  as  well.  As  usually  defined,  a 
negotiable  instrument  differs  from  a  simple  contract,  or  "chose 
in  action,"  in  that  a  "bona  fide  purchaser  for  value,"  innocent  of 
any  irregularity  as  between  the  original  parties  to  the  contract, 
obtains  a  title  to  the  instrument  that  is  free  from  all  personal 
defenses  and  equities  of  prior  parties.  A  purchaser  of  a  non- 
negotiable  instrument,  however,  takes  the  instrument  subject  to 
all  its  original  defenses  and  is  apparently  supposed  to  protect 
himself  by  an  investigation  of  the  origin  and  history  of  the 
instrimient.  While  there  are  some  exceptions  to  this  principle, 
while  transferability  with  a  better  title  is  not  an  exclusive 
attribute  of  a  negotiable  instrument,  it  nevertheless  possesses 
this  attribute  in  a  very  high  degree;  and  it  is  commonly  said  to 
be  its  distinctive  characteristic. 

In  order  to  possess  the  quality  of  negotiability,  an  instru- 
ment must  conform  to  certain  requirements  prescribed  by  the 
custom  of  merchants — ^now  codified  in  the  law  of  negotiable 
instruments.  The  instrument  must  be  drawn  up  in  a  certain 
prescribed  form,  it  must  be  sold  in  a  specified  manner,  certain 
precise  steps  must  be  followed  in  presenting  it  for  payment, 
and  a  definite  procedure  must  be  gone  through  in  giving  notice 
of  its  dishonor  in  case  of  non-payment.'  These  requirements 
originally 'related  only  to  commercial  credit  instruments  in  the 
form  of  promissory  notes  and  bills  of  exchange,  and  the  history  of 
the  law  of  negotiability  is  associated  with  commercial,  rather 
than  investment,  credit  instruments. 

The  law  governing  negotiable  instruments  had  its  inception 
in  the  customs  of  the  mercantile  world;  they  were  bom  of  the 
necessities  and  needs  of  merchants,  as  is  indicated  by  the  fact 
that  the  law  relating  to  such  instruments  is  usually  known 

*  For  details  see  pp.  175-78. 


CREDIT  INSTRUMENTS  173 

as  "the  law  merchant."*  The  custom  of  making  such  notes 
and  bills  of  exchange  payable  to  order  or  bearer  arose  in 
England  early  in  the  seventeenth  century.'  But  until  1756, 
when  Lord  Mansfield,  "the  father  of  the  law  merchant," 
expressed  and  molded  into  the  form  of  definite  rules  of  law  the 
numerous  customs  that  had  grown  up  among  merchants  in 
connection  with  these  instruments,  the  law  of  bills  and  notes 
was  in  a  more  or  less  chaotic  condition.  Mansfield  made  the 
law  merchant  an  integral  part  of  the  great  body  of  the  English 
law,  which  was  inherited  by  the  American  colonies,  and  in 
due  course  by  the  American  commonwealths. 

During  the  first  century  of  American  legal  history,  differing 
interpretations  of  the  law  merchant  developed  in  the  various 
states,  with  the  result  that  commercial  practice  was  seriously 
handicapped.  About  1890,  however,  a  movement  was  initiated 
to  bring  about  a  codification  of  the  law  merchant,  with  a  view 
to  securing  uniformity  in  the  various  jurisdictions.  A  negoti- 
able instruments  bill  was  finally  drafted  in  1896  by  a  "com- 
mittee on  commercial  law,"  and  this  has  since  become  a  law 
in  nearly  every  state  in  the  Union,  in  a  few  instances,  however, 
with  more  or  less  important  modifications. 

The  reason  for  developing  the  principle  that  an  instrument 
in  the  hands  of  an  innocent  third  party  should  be  free  from 
personal  defenses  and  collateral  claims  existing  between  prior 
parties  was  to  facihtate  the  use  of  such  an  instrument  as  a 
means  of  making  payment.  In  the  settlement  of  transactions 
between  merchants  at  the  great  fairs  and  market  places  in 
early  England  there  was  plenty  of  occasion  for  irregularities. 
For  instance,  the  maker  of  an  instrument  might  have  entered 

'  While  originating  in  mercantile  lines,  these  instruments  are  now  used 
quite  as  much  by  manufacturers  as  by  merchants. 

'  Promissory  notes  and  bills  of  exchange  appear  to  have  been  used  by 
various  nations  of  antiquity.  There  are  records  of  their  use  in  Babylonia 
and  Syria,  in  Athens  and  in  Rome.  It  appears,  indeed,  that  by  the  time 
of  Justinian  the  fundamental  principles  of  the  bill  of  exchange  and  the 
promissory  note  were  pretty  well  developed.  After  the  Dark  Ages  we  find 
them  arising  again  with  the  trading  operations  of  Italian  cities;  and  by  the 
middle  of  the  thirteenth  century  the  bill  of  exchange  had  apparently 
become  a  common  document. 


174         THE  FINANCL\L  ORGANIZATION  OF  SOCIETY 

into  the  transaction  without  consideration/  and  if  a  third 
party  were  asked  to  accept  an  instrument  subject  to  such 
defenses  as  an  original  maker  might  set  up,  he  would  usually 
refuse  because  of  the  risks  involved.  Accordingly,  it  was  neces- 
sary to  devise  a  means  whereby  the  purchaser  of  such  an  instru- 
ment would  be  protected  from  irregularities  of  which  he  could 
have  no  cognizance  without  a  careful  investigation  of  the 
origin  and  history  of  the  instrument  in  question. 

To  be  negotiable,  an  instrument  must  meet  certain  essential 
conditions.  In  order  to  guard  against  misinterpretation,  fraud, 
etc.,  the  law  prescribes  that  an  instrument  to  be  negotiable 
must  be  drawn  up  in  a  certain  definite  way.  The  conditions  that 
must  be  met  to  make  an  instrument  negotiable  are  as  follows: 

1.  It  mu^t  be  in  writing.  No  oral  contract  tould  be  negoti- 
able. A  written  contract  may  be  either  in  writing  or  in  printing, 
and  the  writing  may  be  executed  with  any  substance,  as  ink  or 
pencil. 

2.  //  must  be  properly  signed.  It  is  usual  that  the  signature 
be  made  by  writing  in  full  the  name  of  the  signer;  but  a  mark 
or  any  other  character  intended  to  be  the  signature  will  suffice. 
The  signature  is  usually  placed  at  the  close  of  the  instrument, 
although  if  it  is  clear  that  it  is  meant  for  a  signature  it  may  be 
placed  on  any  part  of  the  instrument. 

3.  It  must  be  negotiable  in  form,  that  is,  payable  to  order  or 
bearer.  It  must  be  clearly  shown  to  be  the  intent  of  the  party 
making  the  instrument  to  execute  a  negotiable  paper;  and  to 
make  this  intent  clear  there  must  be  some  expressed  words 
showing  such  a  purpose. 

4.  //  must  be  payable  in  money  only.  The  reason  for  this 
requirement  is  to  insure  the  amounts  being  certain  and  definite. 
By  the  term  "money"  is  meant  the  legal  tender  of  the  country. 

5.  The  amount  must  be  certain.  The  sum  payable  is  con- 
sidered fixed  and  certain  if  it  is  a  definitely  stated  amount  with 
interest,  or  in  stated  instalments,  or  with  exchange  (the  bank's 
charges  for  collection),  or  with  the  cost  of  collection  in  case 
payment  is  not  made  at  maturity. 

'  See  pp.  177-78, 


CREDIT  INSTRUMENTS  175 

6.  It  must  he  payable  to  a  designated  payee.  It  is  not  neces- 
sary to  name  the  specific  party,  but  it  must  be  payable  to  a 
person  or  persons  who  can  be  definitely  ascertained  at  the  time 
of  the  payment. 

7.  It  must  be  payable  absolutely.  If  the  instrument  is  so 
drawn  that  any  condition  might  arise  that  would  render  it  of 
no  effect,  it  is  not  a  negotiable  paper.  Consequently  a  promise 
to  pay  a  certain  sum  out  of  a  designated  fund  is  not  negotiable; 
this  is  the  case  even  though  the  fund  exists  at  the  time  and 
although  the  condition  that  would  nullify  the  contract  had  not 
in  fact  arisen. 

8.  It  must  be  payable  at  a  tims  that  is  certain.  The  date 
of  payment  must  be  definitely  stated;  though  it  may  be  payable 
on  or  before  a  certain  definite  date,  or  at  a  certain  time  after  the 
happening  of  some  future  event.  The  contingent  event  must 
be  certain  to  occur,  however,  or  the  promise  will  not  be  absolute. 

Negotiability  depends  upon  certain  legal  procedure:^ 

I.  Indorsement.  The  indorsement  must  be  on  the  instru- 
ment itself  or  on  a  paper  attached  to  it.  The  indorsement 
must  relate  to  the  entire  instrument;  a  part  cannot  be  trans- 
ferred by  indorsement,  or  a  part  to  one  party  and  the  remainder 
to  another. 

The  obligation  of  an  indorser  to  a  transferee,  like  that  of  a 
drawer  of  a  bill,  is  that  the  indorser  will  pay  the  instrument, 
provided  the  maker  does  not,  and  also  provided  it  is  duly 
presented  for  payment  and  upon  refusal  is  duly  protested  and 
notice  of  protest  given  the  indorser.  In  domestic  bills  and 
notes  the  protest  may  be  omitted  and  instead  notice  of  non- 
payment may  be  given  the  indorser.  It  should  be  noted  that  the 
contract  of  the  maker  of  a  note  or  the  acceptor  of  a  bill  is 
absolute;  each  is  liable  in  any  event.  But  the  contract  of  the 
indorser  and  of  the  drawer  of  a  bill  is  conditional  upon  the 
failure  of  the  maker  or  acceptor  to  pay  upon  proper  protest  and 
notice  to  him. 

If  the  indorser  of  a  note  wishes  to  avoid  any  personal 
liability,  he  may  indorse  "without  recourse"  and  sign  his 

'  For  this  material  I  am  indebted  to  Gano,  Commercial  Law. 


176         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

name.  He  thus  expressly  stipulates  that  he  will  not  be  liable 
if  the  maker  does  not  pay.  There  is  an  implied  warrant, 
however,  that  the  signatures  of  the  maker  and  all  prior  indorsers 
are  genuine,  that  is,  that  they  are  not  forgeries.  The  intent 
and  purpose  of  such  indorsement  is  merely  to  pass  title  to  the 
instrument. 

2.  Presentment  and  demand.  To  fix  the  liability  of  the 
drawer  or  indorser  it  is  necessary  to  present  the  instrument  to 
the  drawee  and  demand  payment.  Presentment  consists  in 
exhibiting  the  instrument  to  the  payer  or  handing  it  to  him, 
while  demand  is  a  request  to  either  accept  or  pay  it  as  the  case 
may  be.  If  the  paper  is  payable  at  a  bank,  the  mere  fact  that 
at  the  time  of  maturity  the  paper  is  at  the  bank  at  which  it  is 
payable  is  sufficient  presentment  and  demand,  provided  the 
drawer  has  knowledge  of  the  fact.  Presentment  must  be  made 
on  the  day  on  which  the  instrument  falls  due,  unless  some 
"inevitable  accident"  or  other  legal  obstacle  prevents  such  pre- 
sentment. The  fact  that  both  the  holder  and  indorser  know 
that  the  note  will  not  be  paid  when  due  and  that  the  maker 
is  dead  and  the  estate  insolvent  does  not  relieve  the  holder 
from  his  obligation  to  make  presentment  and  give  notice  of 
dishonor. 

3.  Notice  of  dishonor.  After  the  payment  has  been  refused 
and  the  instrument  dishonored,  notice  of  such  dishonor  must 
be  given  to  the  drawer  of  a  bill  of  exchange  and  to  each  indorser. 
Any  drawer  or  indorser  to  whom  such  notice  is  not  given  is 
discharged.  K  the  parties  reside  in  the  same  place,  the  notice 
must  be  given  the  following  day.  If  they  reside  in  different 
places  and  notice  is  sent  by  mail,  it  must  be  deposited  in  the 
post-office  so  as  to  go  the  day  following  the  dishonor;  if  given 
otherwise  than  through  the  mail,  it  must  be  done  in  tune  to  bf 
received  as  soon  as  the  mailed  notice  would  have  been.  The 
notice  may  be  given  by  the  holder  or  his  agent  or  by  any 
party  who  may  have  to  pay  the  debt  and  who  is  entitled  to  be 
reimbursed. 

When  there  are  several  indorsers,  the  last  indorser  can  look 
to  the  previous  one,  or,  in  fact,  to  anyone  who  has  indorsed 


'  REDIT  INSTRUMENTS  177 

before  him,  as  well  as  to  the  maker  or  acceptor.  The  notice  of 
dishonor  may  be  either  oral  or  written,  and  can  be  either 
delivered  personally  or  sent  through  the  mail. 

4.  Waiver.  Notice  may  be  waived,  in  which  case  the 
obligations  will  be  assumed  without  the  formal  notification. 
The  indorser  may  also  add  "protest  waived,"  the  effect  being  to 
waive  presentment  and  notice  of  dishonor  as  well. 

5.  Protest.  Protest  is  a  formal  declaration  in  writing  and 
under  seal,  of  an  oflBicer  called  a  notary  public,  certifying  to  the 
demand  and  dishonor.  Protest  of  foreign  bills  of  exchange 
is  necessary,  but  it  is  not  required  in  the  case  of  notes,  checks, 
and  inland  bills,  although  it,  is  often  employed  in  giving  notice 
of  their  dishonor.  The  notary  makes  the  presentment  and 
demand,  and  upon  refusal  to  honor  it  issues  a  certificate,  stating 
that  presentment  and  demand  have  been  made  and  judgment 
refused,  and  further  that  notice  has  been  sent  to  the  maker  and 
all  indorsers  of  the  note. 

There  are  certain  absolute  defenses.  It  has  been  stated  above 
that  a  negotiable  instrument  in  the  hands  of  an  innocent  pur- 
chaser for  value  is  not  subject  to  the  defenses  that  might  be 
interposed  to  it  between  original  parties^ — the  purpose  being  to 
make  such  instrimients  serviceable  as  media  of  exchange. 
But  while  the  law  was  desirous  of  doing  everything  possible 
to  facilitate  commercial  operations,  it  was  necessary  to  protect 
the  original  maker  of  the  instrument  against  abuse.  Certain 
absolute  defenses  have,  therefore,  been  recognized  by  the 
courts.    The  following  are  some  of  the  absolute  defenses: 

1.  Non-delivery.  If  either  the  maker  or  acceptor  of  an 
instrument,  or  the  agent  of  either,  passes  the  instrument  to  a 
third  party;  or  if  it  gets  into  the  hands  of  a  bona  fide  holder 
through  negligence,  the  instrument  is  considered  as  having 
been  delivered.  But  if  the  holder  has  been  deprived  of  its 
possession  by  fraud  or  theft,  he  cannot  be  compelled  to  pay  the 
amount  named  to  anyone.  In  the  view  of  the  law  such  an 
instrument  was  not  delivered  and  no  contract  exists. 

2.  Fratid  in  making  the  instrument.  If  in  the  making  of  the 
instrimient  there  was  fraud  of  a  nature  that  would  vitiate  an 


178         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

ordinary  contract,  the  law  holds  that  no  contract  exists;  and 
the  maker  or  acceptor  of  such  an  instrument  cannot,  therefore, 
be  held  responsible  for  payment  to  innocent  third  parties. 

3.  Alteration  or  forgery.  Where  there  has  been  a  material 
alteration,  or  forgery,  the  law  holds  that  the  minds  of  the 
parties  have  not  met  and  there  is  thus  no  contract.  An  altera- 
tion of  the  terms  of  a  negotiable  instrimient,  either  by  a  party 
to  the  instrument  or  one  in  lawful  possession  of  it,  destroys  its 
validity.  It  is  obvious  that  if  the  law  made  an  individual 
responsible  for  the  payment  of  an  instrument  on  which  his 
name  had  been  forged,  it  would  not  only  work  a  gross  injustice 
upon  the  individual  in  question  but  would  be  a  distinct  encour- 
agement to  the  practice  of  forgery. 

4.  Want  of  capacity  to  contract.  The  contract  represented 
by  the  instrument  is  not  genuine  if  the  parties  to  the  contract 
do  not  have  the  capacity  to  contract,  as  in  the  case  of  an  infant 
or  a  person  who  has  been  adjudged  insane. 

These  absolute  defenses  which  may  be  set  up  by  the  original 
maker  of  an  instrument  do  not  apply,  however,  to  individuals 
who  have  indorsed  the  instrument  as  it  passed  through  their 
hands.  Every  person  who  negotiates  such  an  instrument 
warrants  that  it  is  genuine,  that  he  has  good  title  to  it,  and 
that  all  prior  parties  have  capacity  to  contract.  The  indorser, 
therefore,  unless  the  indorsement  is  without  recourse,  assumes 
liability  for  the  pajonent  of  the  instrument. 

The  law  of  negotiable  instruments  is  extraordinarily  com- 
plex and  the  exceptions  to  and  qualifications  of  the  general  prin- 
ciples that  have  been  categorically  stated  above  are  legion. 
In  this  very  brief  discussion  of  the  transferabihty  and  negotia- 
bility of  credit  instnunents,  the  purpose  has  been  merely  to 
indicate  the  evident  purpose  and  intent  of  the  law  to  render 
these  instruments  more  serviceable  in  meeting  the  needs  of 
commerce  and  industry. 

It  remains  to  note  the  extent  to  which  the  various  forms  of 
instruments  possess  the  different  attributes  under  consideration. 
All  of  them  are  salable;  some  of  them  are  transferable  without 
change  of  ownership  rights;  others  show  improved  title  in  the 


CREDIT  INSTRUMENTS  '  179 

hands  of  an  innocent  third  party;  some  of  them  are  transfer- 
able by  indorsement  only;  others  by  delivery  merely.  In  each 
case  it  appears  that  the  law  has  been  seeking,  consciously  or 
unconsciously,  to  facilitate  the  use  of  the  instrument  in  the 
particular  ways  desired. 

The  foregoing  discussion  of  the  law  of  negotiable  instru- 
ments related  to  commercial  credit  instruments  in  the  form  of 
promissory  notes  and  bills  of  exchange.  Very  little  has  been 
written,  indeed,  upon  the  transferability  and  negotiability  of 
investment  credit  instruments,  owing  to  the  fact  that  the  law 
and  procedure  governing  negotiable  instruments  arose  in  the 
mercantile  or  commercial  credit  field.  But  with  the  develop- 
ment of  corporate  industry,  we  find  in  fact  that  in  greater  or 
lesser  degree  these  principles  have  been  applied  as  well  to 
investment  credit  instruments. 

We  find  that  some  among  the  commercial  credit  instru- 
ments are  used  extensively  as  substitutes  for  money,  while 
others  are  not.  As  we  have  seen  above,  the  origin  of  the 
principle  of  negotiability  and  transfer  by  indorsement  is  as- 
cribed to  the  desire  to  facilitate  the  use  of  notes  and  bills  of 
exchange  as  media  of  exchange.  In  early  times  it  is  probable, 
moreover,  that  promissory  notes  and  bills  of  exchange  fre- 
quently changed  hands  numerous  times,  thus  performing  an 
important  exchange  function.  Nowadays,  however,  it  is  only 
checks,  bank  notes,  and  bank  drafts  that  serve  extensively  as 
media  of  exchange.^  These  instruments  in  fact  serve  as  a 
means  of  effecting,  in  the  United  States,  over  95  per  cent  of  all 
our  wholesale  exchanges  and  in  the  neighborhood  of  80  per  cent 
of  all  exchanges,  including  retail  operations. 

The  reason  that  a  bill  of  exchange  drawn  by  A  against  B 
is  seldom  used  by  A  as  a  means  of  paying  a  debt  owed  by  A  to 
C  is,  first,  that  two  such  obligations  may  not  mature  on  identical 
dates,  and,  second,  that  they  are  not  usually  of  equal  amounts. 
If  B's  debt  to  A  for  $1,000  is  due  March  i,  and  A's  debt  to  C 
for  $1,200  is  due  March  5,  B's  accepted  draft  is  obviously  not 

'  It  is  to  be  noted  that  this  list  includes  only  demand  instruments.  It 
will  be  recalled  that  they  are  not,  strictly,  credit  instruments. 


l8o         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

a  convenient  instrument  with  which  to  pay  C,  The  method 
nearly  always  employed  nowadays  is  for  A  to  deposit  funds 
received  from  B  in  a  bank  and  draw  his  check  against  his 
account  in  favor  of  C  or  ask  the  banker  for  a  cashier's  check 
or  a  draft  on  another  bank  made  payable  to  C. 

The  transferable  qualities  of  a  bond  vary.  One  drawn  to 
order  is  on  a  par  with  the  ordinary  bill  of  exchange  or  promis- 
sory note  drawn  to  order;  it  is  transferable  to  the  same  extent 
and  in  the  same  manner,  and  the  liability  of  the  parties  to  it  is 
fixed  in  the  same  way.  A  bond  payable  to  bearer,  that  is,  a 
non-registered  bond,  passes  title  by  delivery  just  as  does  a  bearer 
commercial  instrument.  A  registered  bond,  however,  is  not 
transferable  by  indorsement,  nor  is  it  negotiable.  Bond  coupons 
are  usually  bearer-instruments,  and  are  transferable  by  delivery, 
with  all  the  legal  consequences  that  follow  from  the  transfer 
of  any  negotiable  bearer-instrument. 

Shares  of  stock  are  ordinarily  transferable  either  by  an 
order  indorsement  or  by  an  indorsement  in  blank.  The  indorse- 
ment operates  as  a  power  of  attorney  to  remove  the  name  of  the 
former  owner  and  place  the  name  of  the  new  owner  on  the 
certificate.  A  mere  possessor  of  a  share  of  stock  (or  of  a 
registered  bond)  has,  however,  no  title  at  all,  even  though  it  is 
indorsed  in  blank;  and  he  cannot  pass  title  to  a  bona  fide 
transferee.  A  certificate  of  stock  is  therefore  not  negotiable  in 
the  ordinary  sense;  there  are  no  formal  requisites;  and  there 
are  no  questions  concerning  the  fixing  of  liabilities  of  the  parties 
to  the  instrument,  etc.  Shares  of  stock  are,  however,  readily 
transferable.* 

QXJESTIONS  FOR  DISCUSSION 

I.      INVESTMENT  CREDIT  INSTRUMENTS 

I.  What  is  the  outstanding  difference  between  a  share  of  stock  and 
a  bond:  (a)  from  the  point  of  view  of  law?  (b)  from  the  point 
of  view  of  investment  ? 

» Bills  of  lading  and  warehouse  receipts  also  possess  in  substantial  degree 
the  qualities  of  transferability  and  negotiability.  While  not  credit  instru- 
ments, bills  of  lading  and  warehouse  receipts  are  evidences  of  ownership  of 
wealth.    For  illustrations  of  these  instruments  see  pp.  98,  400. 


CREDIT  INSTRUMENTS  l8l 

2.  Does  a  shareholder  loan  funds  to  a  corporation?  Is  there  any 
justification  for  calling  a  share  of  stock  a  credit  instrument  ? 

3.  Is  a  bond  always  secured  by  a  mortgage  and  the  right  to  take 
possession  of  certain  definite  property  under  foreclosure  pro- 
ceedings ? 

4.  Does  a  corporation  always  have  outstanding  bonds  with  prior 
claims  to  stock  against  gross  earnings  ? 

5.  In  the  case  of  failure  of  a  corporation  to  pay  interest  and  divi- 
dends, whose  loss  is  likely  to  be  greater,  that  of  the  bondholders 
or  of  the  shareholders  ? 

6.  What  is  meant  by  preferred  stock?  oimulative  preferred?  pre- 
ferred participating?  Which  would  you  rather  own,  preferred 
or  common  stock  ?  Why  ?  Would  your  answer  always  be  the 
same  ?    Upon  what  factors  might  it  depend  ? 

7.  What  is  meant  by  par  value  ?  market  value  ?  face  value  ?  book 
value  ? 

8.  How  could  the  market  value  of  a  share  of  stock  be  $450  when 
its  par  value  is  only  $100?  How  could  its  market  value  be 
only  $8  ? 

9.  What  is  meant  by  issuing  stock  without  par  value?  Explain 
how  dividends  could  be  ascertained  under  such  circiunstances. 
Explain  how  an  investor  would  know  how  much  such  stock 
was  worth. 

10.  What  are  the  advantages  of  issuing  stock  without  par  value? 

11.  What  is  the  nature  and  purpose  of  stockholders'  rights? 

12.  Which  of  the  different  points  of  view  from  which  bonds  are 
classified  do  you  regard  as  most  significant  ? 

13.  How  do  you  account  for  the  development  of  so  many  different 
types  of  security  for  bond  issues  ? 

14.  What  is  the  meaning  of  each  term  under  the  heading  on  page  156. 
"Conditions  Governing  the  Payment  of  Interest  or  Principal"? 

15.  What  are  the  reasons  for  issuing  short-term  notes  ? 

1 6.  Why  are  short-term  notes  usually  arranged  in  serial  form  ?  What 
is  the  security  back  of  short-term  notes  ? 

17.  A  corporation  has  outstanding  $3,000,000  of  5  per- cent  bonds, 
$1,000,000  preferred  stock  at  7  per  cent,  and  $1,000,000  of  com- 
mon stock.  If  the  net  earnings  (after  interest  has  been  paid) 
are  $150,000,  what  dividends  could  be  paid  on  common  stock? 
If  the  following  year  the  net  income  (before  pajdng  interest) 
should  be  cut  in  two,  what  dividends  could  be  pjaid  ?    If  upon 


iSa         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

reorganization  $1,000,000  of  bonds  were  exchanged  for  preferred 
stock,  what  would  be  the  state  of  affairs:  (a)  assiiming  net 
income  to 'be  $150,000?   (b)  $75,000? 

n.      COMMERCIAL  CREDIT  INSTRUMENTS 

18.  What  is  the  distinction  between  commercial  and  investment 
credit  instruments  ? 

iQ.  What  are  the  two  principal  types  of  conmiercial  credit  instru- 
ments ? 

20.  For  what  different  purposes  may  promissory  notes  be  drawn  ? 

2 1 .  What  is  a  joint  note  ?    a  joint  and  several  note  ? 

22.  Define  a  bill  of  exchange. 

23.  From  what  different  points  of  view  may  bills  of  exchange  be 
classified  ? 

24.  Where  did  ihe  terms  "foreign"  and  "domestic"  bills  originate? 

25.  What  is  meant  by  this:  "firstof  exchange,  second  being  impaid"? 
What  is  the  purpose  of  duplicate  bills  ? 

26.  How  does  a  certified  check  differ  from  an  ordinary  check  ? 
27s  How  does  a  cashier's  check  differ  from  a  personal  check? 

28.  How  does  a  personal  check  differ  from  a  bank  acceptance  ? 

29.  How  does  a  bank  draft  differ  from  an  individual  draft  ? 

30.  What  would  you  call  an  order  drawn  by  a  bank  against  an 
individual  ? 

31.  What  is  meant  by  "accepting  a  draft,"  and  what  is  the  party 
who  accepts  it  called  ? 

32.  A  may  draw  a  draft  against  B  for  a  debt  of  $1,000,  or  B  may 
write  a  promissory  note  for  $1,000  in  favor  of  A.  What  will 
determine  which  instrument  will  be  used  ? 

33.  Suppose  A  discounts  the  promissory  note  or  sells  the  accepted 
draft  to  a  bank:  to  whom  would  the  bank  look  for  pa5anent  in 
each  case,  (a)  primarily,  (b)  secondarily? 

34.  Do  you  think  that  it  is  incorrect,  strictly  speaking,  to  call  a 
check  a  credit  instrument  ? 

35.  Draw  up  a  classification  of  the  various  forms,  of  instruments, 
showing  which  are  really  credit  instruments  and  which  are  not. 

m.     THE  USE  OF  CREDIT  INSTRUIHENTS  IN  TRANSFERRING  WEALTH 

36.  State  the  different  legal  principles  that  serve  to  make  these 
various  instruments  serviceable  as  a  means  of  transferring  wealth. 

37.  What  devices  have  made  these  instruments  readily  transferable  ? 


CREDIT  INSTRUMENTS  183 

38.  What  peculiar  advantages  in  the  matter  of  transferability  has  a 
negotiable  instrument  ? 

39.  A  negotiable  instrument  is  handled  in  accordance  with  certain 
"customs  of  the  merchants."  Enumerate  them.  Is  it  only 
merchants  who  use  notes  and  bills  of  exchange  at  the  present 
time? 

40.  What  was  the  reason  for  the  development  of  the  principle  of 
negotiability  ? 

41.  Can  you  account  for  the  extension  of  the  principle  of  negotia- 
bility to  bonds  on  the  same  grounds  ? 

42.  Why  is  it  that  only  bank  drafts  and  checks  are  used  extensively 
as  media  of  exchange  ? 

43.  How  do  you  account  for  the  fact  that  some  of  these  instruments 
are  fully  negotiable,  others  partly  negotiable,  others  only  readily 
transferable  ?  Does  it  seem  to  you  probable  that  the  law  con- 
sciously sought  to  facilitate  the  use  of  each  of  these  instruments 
in  the  way  to  which  it  was  best  adapted. 

44.  Give  a  case  in  which  the  title  would  be  good  in  the  hands  of  a 
bona  fide  holder  for  value,  but  not  enforceable  between  the 
original  parties. 

45.  What  is  the  purpose  of  "indorsement  without  recourse"?  Is 
such  an  indorsement  of  any  value  from  the  standpoint  of  security  ? 

46.  What  is  an  indorsement  in  blank  ? 

47.  A  note  with  four  indorsements  is  dishonored.  To  whom  may  the 
holder  look  for  reimbursement  ? 

48.  What  is  meant  by  a  "no  protest"  note ?    What  is  the  effect ? 

49.  How  would  you  indorse  a  note  to  be  sent  through  the  mail  ? 

50.  How  do  you  indorse  checks  payable  to  yourself  ? 

51.  Is  the  following  a  negotiable  instrument? 

Chicago,  III.,  May  17,  1904 
Due  John  Jones,  one  thousand  dollars. '  Value  received. 

John  Smith 

52.  An  instnmient  is  written  in  lead  pencil  in  the  following  form: 

Chicago,  Illinois 
I,  John  Jones,  promise  to  pay  John  Smith,  or  order,  fifty  dollars,  value 
received. 

Mention  several  particulars  in  which  this  note  is  not  in  the  usual 
form.    Is  it  negotiable  ? 


l84         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

53.  Is  the  following  negotiable? 

St.  Loins,  Mo.,  June  i,  1915 
Three  months  after  date,  for  value  received,  I  promise  to  pay  John  Doe, 
or  order,  one  hundred  dollars,  or  ninety-five  dollars  if  payable  two 
months  after  date. 

RiCHABD  Roe 

54.  Is  the  following  a  negotiable  instrument  ? 

New  York,  N.Y.,  June  i,  1915 
For  value  received,  I  promise  to  pay  to  George  Rogers,  or  order,  one 
hundred  dollars  when  he  marries. 

William  Stone 

Would  the  foregoing  be  negotiable  if  it  read  "when  he  shall  be 
twenty-one  years  of  age  "  ? 

55.  A  check  on  a  Chicago  bank  is  given  by  A  to  B  in  Chicago  on 
January  25.  It  is  not  presented  for  payment  on  January  26, 
and  on  January  27  the  bank  fails.    Whose  is  the  loss  ? 

56.  A  check  on  a  Chicago  bank  is  given  to  A  in  New  York  on  May  15. 
It  reaches  the  Chicago  bank  on  May  20,  but  the  bank  had  closed 
its  doors  May  18.  Whose  is  the  loss?  WTiat  principle  should 
govern  the  decision  in  this  and  in  the  preceding  case  ? 

57.  What  is  meant  by  absolute  defenses  ? 

58.  What  is  the  purpose  of  such  defenses  ? 

59.  Draw  up  in  proper  form  a  negotiable  instniment. 

REFERENCES  FOR  FURTHER  READING 

Gano,  D.  Ctirtis:   Commercial  Law,  pp.  116-53. 
Hagerty,  James  E.:   Mercantile  Credit,  chap.  ii. 
Moore,  Underbill:   Commercial  Paper. 
Prendergast,  Wm.  A.:  Credit  atid  Its  Uses,  chaps,  iii-vii. 
The  Credit  Monthly.    Published  by  the  National  Association  of 
Credit  Men. 


CHAPTER  Xm 

THE  MARKETING  OF  LOW-GRADE 
SECURITIES 

In  this  chapter  we  are  to  consider  the  financial  machinery 
that  has  been  developed  for  the  marketing  of  low-grade,  or 
speculative,  securities  and  the  problems  of  regulation  which 
are  associated  therewith.  The  financial  machinery  employed 
in  the  distribution  of  low-grade  securities  is  indicated  at  the 
extreme  left  of  the  diagram  on  page  136.  The  investment 
banking  institutions,  shown  nearer  the  center  of  the  chart, 
are  associated  with  the  marketing  of  high-grade,  or  non- 
speculative,  securities.  These  will  be  considered  in  the  follow- 
ing chapter. 

It  is  impossible  to  give  a  very  precise  definition  of  low-grade 
securities,  for  there  is  no  hard-and-fast  line  of  demarcation  from 
high-grade  issues.  But  in  general  the  term  refers  to  securities 
of  such  a  nature  that  the  risk  of  loss  to  the  investor  is  acknowl- 
edged to  be  relatively  large.  There  would  seem  to  be  at  least 
four  distinct  types  of  securities  that  may  be  regarded  as  involv- 
ing large  risks:  (i)  those  that  are  fraudulent;  (2)  those  issued 
by  corporations  in  new  and  hence  untested  lines  of  industry; 
(3)  those  issued  by  new  and  hence  untried  companies  in  staple 
lines  of  industry;  and  (4)  those  issued  by  companies  engaged 
in  lines  that  are  essentially  speculative  in  their  nature — that 
normally  involve  a  high  degree  of  risk.  Another  classification  of 
low-grade  issues  is  found  in  the  securities  designated  "  Class  D  " 
under  the  Illinois  Securities  Law,  a  digest  of  which  is  presented 
on  pages  198-203  below. 

It  should  be  added  that  low-grade  securities  virtually 
always  take  the  form  of  shares  of  stock.  Borrowing  by  means  of 
bond  issues  is  essentially  a  later  stage  in  the  process  of  raising 
capital,  for  the  simple  reason  that  the  property  basis  required 
as  security  for  bonds  usually  implies  a   "going  concern," 

185 


l86         THE  FINANCIAI.  ORGANIZATION  OF  SOCIETY 

the  capital  for  which  has  aheady  been  raised  by  stock  sub- 
scriptions; and  in  any  event  the  bondholder  is  more  amply 
protected,  and  hence  the  risks  assumed  are  less. 

The  sale  of  securities  of  new  corporations,  except  in  the  case 
of  relatively  small  concerns,  the  stock  of  which  is  entirely 
subscribed  by  a  small  group  of  investors,  usually  involves  what 
is  known  as  "promotion"  of  the  sale  of  securities.  If  capital 
is  to  be  raised  for  a  new  corporation  it  is  obviously  necessary 
that  the  securities  be  brought  to  the  attention  of  possible 
investors,  just  as  it  is  necessary  to  commend  manufactured 
commodities,  through  advertising,  to  the  good  graces  of 
potential  purchasers.  The  marketing  of  low-grade  securities, 
however,  has  been  subject  to  such  grave  abuses  that  many 
have  urged  that  "stock  promotion"  be  forbidden  by  law. 

The  problem  of  controlling  the  issue  and  sale  of  low-grade 
securities  is  twofold  in  its  nature:  first,  to  prevent  the  marketing 
of  fraudulent  and  practically  worthless  shares;  second,  to  make 
it  possible  for  the  potential  investor  to  secure  adequate  informa- 
tion upon  which  to  base  a  reasonably  intelligent  judgment 
of  the  value  of  honest,  but  highly  speculative  securities. 

I.    THE  PROMOTION  OF  FRAUDULENT  AND 
WORTHLESS   SECURITIES 

Hundreds  of  milUons  of  dollars  are  annually  taken  from 
ignorant  investors  by  the  sale  of  utterly  worthless  securities. 
The  mail  frauds  alone  that  have  been  discovered  and  stopped 
by  the  federal  government  in  a  single  year  have  reached  a  total 
of  $129,000,000.  There  is,  of  course,  no  way  of  estimating 
the  voliune  of  undetected  fraud;  and  there  are  numerous 
cases  lying  within  the  twilight  zone  between  fraud  and  legiti- 
macy for  which  the  laws  afford  no  redress. 

The  post-war  period,  particularly,  has  been  marked  by  the 
issue  of  enormous  volumes  of  highly  speculative  securities. 
Literally  thousands  of  companies  have  been  organized  for  the 
sale  of  securities  in  enterprises  of  every  sort.  The  movement 
has  been  accelerated  by  virtue  of  the  increased  earnings  obtained 


MARKETING  OF  LOW-GRADE  SECURITIES  187 

by  many  people  during  the  war,  and  by  the  habit  of  investing 
that  was  engendered  by  the  Liberty  Loan  campaigns.  Indeed, 
the  possession  of  Liberty  Bonds  has  been  made  the  basis  of 
extensive  stock-selUng  campaigns,  thousands  of  individuals 
having  been  induced  to  exchange  their  bonds  for  securities 
promising  fabulous  returns.  Despite  all  the  efforts  at  sup- 
pression that  have  been  made  by  state,  municipal,  and  federal 
governments,  hundreds  of  millions  of  dollars  have  been  taken 
from  the  pockets  of  the  people  by  fraudulent  investment 
schemes. 

The  promoter  of  a  new  issue  of  securities  has  various  means 
at  his  disposal  for  reaching  the  investing  public.  As  the  diagram 
on  page  136  indicates,  one  of  these  means  is  newspaper  adver- 
tising, a  method  that  has  been  followed  very  extensively  in 
recent  years.  It  is  particularly  efficacious  in  boom  periods  when 
the  general  public  is  both  prosperous  and  credulous.  The 
nature  of  the  appeal  that  may  be  made  is  indicated  in  the  sample 
advertisements  on  pages  192-97  below.  A  second  method  is  the 
sending  of  circulars  through  the  mails  to  a  list  of  selected  names. 
This  method  is  perhaps  the  cheapest  of  any.  Its  effectiveness 
largely  depends  upon  the  care  and  judgment  with  which  the 
list  of  names  has  been  chosen.  Another  method  involves  the 
employment  of  salesmen  who  interview  potential  investors 
and  attempt  to  convince  them  of  the  exceptional  nature  of  the 
opportunity  offered.  While  more  costly  than  newspaper  or 
circular  advertising,  this  method  possesses  the  advantage  that 
goes  with  personal  contact.  The  plausible  salesman,  who 
can  look  a  hesitating  and  stammering  investor  in  the  eye  and 
pat  him  on  the  shoulder  at  the  psychological  moment,  is  in  a 
much  more  strategic  position  to  silence  doubts  than  is  the 
cold  page  of  a  newspaper  or  circular  letter.  It  is  not  to 
be  considered  that  the  foregoing  methods  are  necessarily 
mutually  exclusive.  All,  indeed,  may  be  resorted  to  simul- 
taneously. 

The  nature  of  a  great  deal  of  the  "promotion"  that  is  being 
engaged  in  every  year  may  be  surmised  from  the  following  adver- 
tisement recently  appearing  in  a  New  York  newspaper,  which 


1 88         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

sets  forth  the  necessary  qualifications  for  a  writer  of  promotion 
literature: 

Wanted:  Well-educated  young  man  to  write  literature  and 
circulars  for  stock  broker.  No  knowledge  of  securities  necessary. 
Must  have  good  imagination  and  flow  of  language  and  write  in  a 
convincing  style. 

There  are  well-known  "earmarks"  of  a  swindle.  As  a  result 
of  an  analysis  of  a  large  number  of  promotions  that  proved  to 
be  swindles,  the  following  earmarks  of  a  stock-offering  of 
doubtful  or  fraudulent  character  have  been  compiled.  It 
should  be  stated,  however,  that  honest  promotion  schemes 
sometimes  possess  some  of  these  "earmarks": 

1.  The  argument  that  the  investor  should  buy  immediately 
because  the  price  of  stock  will  be  advanced  within  a  short  time. 
It  is  obvious  that  the  arbitrary  advancing  of  the  price  by  a 
promoter  does  not  increase  the  true  value  of  the  security. 

2.  The  argument  that  the  investor  should  send  a  remittance 
by  return  mail,  or,  better  still,  by  wire  because  there  are  only 
a  few  shares  left  for  distribution. '  Such  golden  opportunity, 
however,  usually  knocks  a  second  time. 

3.  The  argument  that  the  association  of  prominent  men  with 
a  company  is  a  guarantee  of  the  merit  of  the  stock  as  an  invest- 
ment. It  is  assumed  in  this  connection  that  the  typical  investor 
will  not  know  that  most  successful  business  men  have  lost  a 
great  deal  of  money  in  stock  purchases. 

4.  The  argument  that  other  companies  engaged  in  the  same 
or  a  similar  line  of  business  have  made  millions  from  an  original 
investment  of  little  or  nothing. 

5.  The  argument  that  the  company  desires  to  place  its  stock 
in  the  hands  of  very  small  investors,  so  that  control  may  not 
become  vested  in  a  coterie  of  capitalists.  A  similar  argument  is 
that  the  company  desires  to  permit  only  a  limited  number 
of  persons  in  each  state  or  in  each  city  to  buy  the  stock.  Demo- 
cratic organization  and  control  as  a  means  of  preventing  the 
capitalistic  octopus  from  reaping  the  rewards  of  the  wonderful 
idea  to  which  the  company  has  the  exclusive  right  is  regarded  as 
a  very  effective  selling  device.    Companies  of  this  sort  always 


MARKETING  OF  LOW-GRADE  SECURITIES  189 

delight  in  the  opportunity  to  enrich  people  who  find  themselves 
in  moderate  circumstances. 

6.  The  argument  that  the  company  has  orders  and  con- 
tracts already  in  sight,  or  under  consideration,  or  about  to  be 
under  consideration,  which  will  insure  large  earnings  on  the 
stock  issued.  It  will  be  apparent,  however,  that  even  when  a 
company  has  such  contracts  actually  in  force,  the  point  to 
remember  is  that  money  may  be  lost  as  well  as  made  on  an 
agreement  to  do  a  certain  thing  at  an  agreed  price. 

7.  The  argument  that  the  company  has  assets  largely  in 
excess  of  its  stock  issue.  Mention  is  seldom  made  of  offsetting 
liabilities. 

Among  the  physical  earmarks  of  swindling  promotion 
literature,  the  following  have  been  listed: 

1.  A  picture  of  the  president  of  the  corporation.  He  is 
usually  a  clean-cut  aggressive  t)^  of  individual,  distinctively 
American  in  appearance. 

2.  A  picture  of  a  factory  or  of  an  oil  field  or  of  a  mine 
shaft,  in  some  part  of  which  is  displayed  a  sign  showing  that 
the  photograph  is  genuine. 

3.  The  adoption  of  a  name  that  is  similar  to  that  of  a 
well-known  firm  or  corporation. 

4.  Absence  of  reputable  financial  or  banking  support. 

5.  Testimonials  of  character  by  unknown  persons  with 
imposing  business  titles. 

6.  TJie  listing  of  high-grade  securities  in  circulars  promoting 
worthless  enterprises. 

7.  Sales  on  the  instalment  plan.  The  instalment  plan  is  to 
be  distinguished,  however,  from  the  partial-payment  plan  used 
by  many  reputable  brokers  for  well-seasoned  listed  stocks. 
Instalment  sales  do  not  usually  permit  the  investor  to  require 
a  return  of  the  money  invested,  even  in  case  of  fraud.  On  a 
partial-payment  contract  with  a  reputable  broker,  however, 
the  investor  may  order  the  sale  of  his  stock  at  the  market  price 
and  the  immediate  remittance  of  his  balance. 

The  career  of  a  promoter  is  vivid.  There  have  been 
innumerable  cases  of  downright  fraudulent  promoters  who  have 


100         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

carried  on  their  operations  for  many  years.  The  following 
biography  of  a  promoter  is  typical:' 

Death  stepped  in  yesterday  and  cut  short  the  kaleidoscopic 
financial  career  of  George  UnderhiU,  past  master  in  the  art  of  extract- 
ing the  mites  from  the  pockets  of  the  middle  class  in  exchange  for 
briUiantly  colored  stock  certificates. 

Underbill's  most  recent  stock-selling  venture  was  the  Spring 
Nut  Lock  Company,  said  to  be  capitalized  for  $4,000,000,  the  stock 
of  which  was  peddled  in  small  lots,  chiefly  by  appeals  sent  through 
the  mails  and  advertising  in  magazines  circulating  in  the  small  towns 
and  rural  communities. 

Another  venture  of  recent  date  was  the  organization  of  a  sjoidi- 
cate  to  promote  what  was  called  the  Ford  machine  gun. 

He  embarked  in  the  promotion  business  in  1904,  when  he 
attempted  to  float  the  Tennessee  Development  Company.  This 
concern,  which  was  one  of  his  own  creations,  was  capitalized  at 
$500,000,  and  Underbill  endeavored  to  exchange  stock  certificates 
for  gold  by  extensive  advertising. 

He  painted  rosy  pictures  of  the  money-making  possibilities  of 
this  stock,  playing  up  the  idea  of  a  "triple  profit."  The  plan  was  to 
buy  Tennessee  lands  from  which  the  timber  would  be  cut,  making 
one  profit;  then  sheep  were  to  be  turned  loose  to  graze  upon  the  land, 
thus  making  a  second  profit;  and  finally,  coal  could  be  mined  from 
beneath  it,  thus  reaping  a  third  profit. 

But  Underbill  waxed  even  more  eloquent  in  his  advertising 
literature,  holding  out  as  further  inducements  to  possible  investors, 
in  addition  to  the  triple  profit,  an  added  "probable  oil  find"  and 
"other  products  from  the  land,  such  as  fruit,  and  farm  produce, 
the  bottling  and  sale  of  mineral  water,  the  sale  of  pipe  clay,  the 
raising  and  sale  of  poultry,  hogs,  cattle,  mules  and  horses,  the  breeding 
of  Angora  goats  for  fanciers,  etc." 

He  intimated  that  as  much  as  60  per  cent  in  annual  profits  might 
be  realized  from  this  venture,  but  according  to  persons  who  investi- 
gated the  proposition  the  whole  scheme  revolved  around  a  hundred- 
acre  farm  in  Tennessee,  owned  by  Underbill's  father. 

In  March,  1901,  he  was  president  and  treasurer  of  the  George 
Underbill  Company,  advertising  agents,  which  was  forced  intc 
bankruptcy.  LiabiUties  of  the  company  agreggated  $39,396,  and 
creditors  received  practically  nothing. 

*  From  the  Chicago  Tribune,  April  5,  19 18. 


MARKETING  OF  LOW-GRADE  SECURITIES  19 1 

In  1906  Underbill  launched  into  the  promotion  business  again, 
and  became  fiscal  agent  for  the  Hoosac  Tunnel  Mining  Company. 
He  sold  $200,000  worth  of  stock  during  that  year,  but  the  company 
proved  a  failure. 

During  the  same  year  he  sold  stock  in  the  Trinity  Mining  Com- 
pany. Some  of  it  was  sold  as  low  as  35  cents  a  share.  Later  he 
sold  stock  in  the  Copper  Gold  Mines  Leasing  Company  and  was 
also  active  in  a  concern  known  as  the  Continental  Securities 
Company. 

In  1915  Underbill  sold  stock  in  the  Eagle  Macomber  Motor 
Company  of  Sandusky,  Ohio.  On  May  13,  1915,  he  was  arrested  by 
the  federal  authorities  on  orders  from  Cleveland,  Ohio,  where  he 
had  been  indicted  on  a  charge  of  using  the  mails  to  defraud.  This 
was  in  connection  with  the  sale  of  2,000  shares  of  stock  in  the  Buick 
Oil  Company  to  a  woman  in  Youngstown,  Ohio. 

II.    THE  SALE  OF  HIGHLY  SPECULATIVE 
SECURITIES 

A  large  amount  of  capital  is  annually  raised  by  corporations 
in  lines  of  business  that  are  highly  speculative,  such  as  oil  and 
mining.  Such  enterprises,  of  course,  afiford  a  fertile  field  for 
the  operations  of  the  sharper;  but  even  where  they  are  not 
fraudulent  they  are  nevertheless  often  based  upon  such  slender 
possibilities  of  success  that  the  losses  to  innocent  investors 
are  quite  as  serious  as  in  the  cases  of  outright  fraud.  Perhaps 
the  most  notable  recent  cases  of  this  type  are  found  in  the  oil 
fields  of  Kansas,  Texas,  and  California.  The  discovery  of  oil 
in  various  parts  of  the  country  has  laid  the  basis  for  the  wildest 
sort  of  speculation  in  land  adjacent  to  the  oil  fields.  For 
instance,  the  development  of  the  Southern  Kansas  Pool  resulted 
in  the  organization  of  a  veritable  horde  of  companies,  each  with 
prospectus  and  maps  showing  the  wonderful  profits  to  be  secured 
from  oil  development  in  adjoining  coimties.  Nor  is  such 
promotion,  when  once  well  started,  to  be  confined  merely  to 
oil.  Hundreds  of  salesmen  travel  over  the  farming  sections  of 
the  state,  "offering  shares  in  every thmg  from  oil  prospects  to 
motor  trucks  and  from  car  couples  to  adding  machines." 
Under  the  Blue  Sky  Law  of  Kansas  there  had  been  authorized 


192         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

up  to  July  i8,  1919,  238  stock-selling  companies.  Of  these, 
142  were  oil  companies  and  almost  every  county  in  the  state 
was  represented.  Besides  these  companies  there  were  scores 
of  others  disposing  of  units  in  oil  leases,  a  device  that  has  been 
developed  as  a  means  of  circumventing  the  regulations  imposed 
by  the  Securities  Act. 

The  following  is  part  of  a  circular  letter  used  in  advertising 
a  Texas  oil  project: 

WHAT  WILL  YOUR  ANSWER  BE  ? 

When  the  fortunes  made  by  the  investors  in  the  oil  fields  of 
North  Central  Texas  have  been  written  Into  history;  when  the 
CHILDREN  and  the  grandchildren  of  these  investors  have  been 
made  prosperous  and  independent  and  are  enjoying  the  advantages 
of  higher  education  and  world  travel  which  wealth  alone  can  give — 

WHAT  WILL  BE  YOUR  EXCUSE  TO  YOUR  CHILDREN? 

— that  they  do  not  also  have  the  advantages  which  a  small 
investment  in  the  world's  greatest  and  probably  the  last  Frontier  of 
over-night  Fortunes  in  gushing  oil  wells,  would  have  made  possible  ? 

When  your  children,  or  your  grandchildren  ask  why  you,  too,  did 
not  share  in  the  profits  of  this,  the  world's  greatest  oil  boom — 

WHAT  WILL  YOUR  ANSWER  BE? 

Can  you  tell  them  that  you  did  not  have  the  nerve  ? 

Can  you  tell  them  that  you  did  not  have  the  opportunity  ? 

That  might  be  true  if  we  had  not  sent  you  the  facts  concerning 
the  greatest  oil  field  the  world  has  ever  known — it  might  be  true  if 
newspapers  and  magazines  from  Maine  to  California,  from  the  Satur- 
day Evening  Post,  the  Golden  Rule,  Truth,  and  other  well-known, 
reliable  publications  on  down  to  the  little  local  newspapers,  had  not 
carried  page  after  page  of  news  of  this  oil  boom  that  you  surely  have 
had  a  chance  to  read,  giving  indisputable  evidence  that  some  of  the 
nation's  greatest  and  quickest  small  fortunes  have  been  and  are 
being  made  right  now  in  Texas  oil  fields. 

Can  you  tell  your  children  or  your  children's  children  that  you 
were  a  Doubting  Thomas — that  you  stood  back  and  waited  while 
men  and  women  from  all  over  the  world  with  more  nerve  and 
courage  than  yourself  bought  up  all  of  the  available  chances  to  make 
fortunes  ? 


MARKETING  OP  LOW-GRADE  SECURITIES  193 

Can  you  explain  to  them  that  you  didn't  have  sufficient  ready 
cash  to  take  advantage  of  this  big  Texas  oil  boom  ?  You  might  use 
this  reason  with  success  but  our  monthly  pajnnent  plan  makes  it 
possible  for  even  the  smallest  wage  earner  to  get  a  share  of  the 
profits  in  this  grtat  oil  boom  where  $100  has  so  often  made  a  smaP 
fortune  of  $10,000  to  $100,000. 

Can  you  tell  your  children  or  your  grandchildren  that  you  doubted 
the  sincerity  of  the  Trust  Company  which  brought  to  your 
notice  the  chance  to  share  in  the  profits  of  the  great  Texas  oil 
boom? 

This  might  have  furnished  you  an  excuse  if  we  had  not  sent  you 
the  best  evidence  on  earth— evidence  written  by  men  and  women  who 
live  in  all  parts  of  the  country  who  have  told,  in  personal  letters,  of 
the  satisfaction  and  profits  gained  by  dealing  with  us  and  following 
our  recommendations. 

The  limited  number  of  shares  in  the  Pre-organization  Syndicate 
of  the  Ranger-Texas  Oil  Company  which  you  have  now  a  chance  to 
acquire,  are,  without  doubt,  the  most  desirable  shares  we  have  ever 
offered  in  our  entire  history,  and  here  is  exactly  the  reason  that  we 
say  so: 

In  the  first  place,  this  Syndicate  privilege  is  being  extended  to 
only  a  limited  and  carefully  selected  few  whom  we  regard  as  leaders 
in  their  community,  and  you  are  one  of  these.  By  making  you  a  large 
and  quick  profit  we  will  not  only  get  your  future  patronage,  but  that 
of  your  friends  as  well. 

You  can  only  get  the  limit  to  which  any  one  person  is  entitled, 
which  is  200  shares.  The  present  selling  price  is  $12.00  per  share, 
but  we  cannot  guarantee  this  quotation  unless  you  place  your  order 
by  wire,  following  it  with  the  enclosed  application. 

This  application  also  gives  you  an  option,  until  July  30th,  on 
double  the  nmnber  of  shares  that  you  subscribe  for  at  this  time,  at 
only  $16.00  a  share.  We  have  every  reason  to  believe  that  these 
shares  wiU  be  selling  for  at  least  $25.00  and  possibly  $30.00  before 
July  ist;  therefore  you  have  a  chance  to  clean  up  a  nice  sum  of 
money  on  your  option,  without  investing  a  cent. 

What  will  your  answer  be  ?  Have  you  the  nerve  and  the 
courage  to  trust  your  own  judgment  this  very  minute  rather  than 
face  your  children  and  your  children's  children  with  excuses,  and  get 
a  telegram  off  to  us  reserving  the  number  of  shares  you  want?  If 
you  have,  it  may  prove  to  be  the  turning  point  in  your  life. 


194         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  following  is  a  portion  of  a  full-page  advertisement,  with 
photograph,  of  an  investment  opportunity  in  the  automobile 
industry.  So  far  as  the  author  knows  the  company  is  a  bona 
fide  one  honestly  conducted: 

CHICAGO'S  MIRACLE  MAN 

How  he  has  broken  all  records  of  Industrial 

Achievement 

by  piling  up  Assets  of  $2,000,000.00 

in  One  Year  from $100,000.00 

1074%  Increase  1049%  Increase  2000%  Increase 

in  Sales  and  Production       in  Factory  Floor  Space         in  Assets 

In  putting  Chicago  on  the  map  in  one  short  year  as  a  quantity 
producer  of  automobiles,  Mr.  H.  J.  Hinman,  Chicagb's  Miracle  Man, 
has  written  the  most  brilliant  and  romantic  chapter  in  Motordom's 
wondrous  history.  The  plain  facts  concerning  Hinman's  Herculean 
Accomplishments  read  like  a  financial  fairy  tale — a  story  too  good  to 
be  true.  Yet  the  proof  exists  in  his  Company's  big,  modern  factory 
buildings  out  at  8ist  Street  and  Arrow  Avenue,  throbbing  with  the 
high-pressure  activity  of  hundreds  of  workmen  rushing  production  to 
the  limit. 

It  exists  in  the  huge  circus  tents  used  to  provide  extra  manu- 
facturing space,  and  in  the  great  volume  of  orders  on  hand,  with  cash 
deposits  paid  in  advance,  sujfficient  to  run  the  factory  almost  a  year. 

But,  most  surprising  of  all,  it  exists  in  the  Company's  large  cash 
reserve  fund  and  in  its  Balance  Sheet,  showing  net  profits  which  for 
a  Company  so  young  seem  little  short  of  miraculous. 

Hinman  has  built  up  the  Waltham  Motor  Car  Corporation  in  one 
year  from  a  humble  beginning  in  a  small  rented  frame  building  to  a 
Great  Thriving  Industrial  Giant  with  108,800  square  feet  of  modern 
factory  space.  Even  with  this  record-breaking  increase  in  manu- 
facturing faciUties,  the  Company  is  compelled  to  use  2  huge  circus 
tents  to  increase  working  space. 

He  has  increased  the  factory  output  in  one  year  from  724  cars  to 
the  production  of  7,776  cars  which  will  be  attained  during  1917. 

He  has  created  a  demand  for  Waltham  Sixes  that  from  the  very 
beginning  has  kept  the  factory  "snowed  under"  with  orders  not- 
withstanding the  greatest  ratio  of  production  increase  ever  dared 
by  any  company  in  one  year 


MARKETING  OF  LOW-GRADE  SECURITIES  195 

» 

He  has  multiplied  the  assets  of  approximately  $100,000.00  one 
year  ago  to  the  Company's  more  than  $2,000,000.00  of  today. 

He  has  done  all  these  things  practically  from  a  standing  start, 
while  at  the  same  time  he  was  financing  his  Company  and  perfecting 
a  car  which  is  today  the  acknowledged  world's  champion  at  its  price, 
and  holder  of  records  for  speed,  endurance,  and  economy. 

He  has  caused  more  than  13,000  live  American  citizens  to  buy 
stock  in  his  Company  (more  stockholders  than  the  three  greatest 
automobile  companies  in  the  world  combined),  thus  providing  him 
not  only  with  ample  working  capital,  but  at  the  same  time  com- 
prising, with  their  famiUes,  a  great,  enthusiastic  army  of  65,000 
vitally  interested  "boosters,"  all  singing  the  praises  of  the  beautiful 
Waltham  Six. 

The  Waltham  Company  is  not  in  need  of  fimds.  It  has  been 
generously  supplied  by  its  stockholders  with  ample  capital  to  cover 
all  its  current  manufacturing  requirements. 

Hinman,  with  the  rare  foresight  and  business  prudence  which  has 
characterized  his  course  throughout,  has  always  rigidly  adhered  to 
the  pohcy  he  established  for  his  Company  at  the  beginning,  of  keeping 
on  hand  a  large  cash  reserve  fund.  The  Company  has  thus  not  only 
been  safeguarded  against  possible  business  emergencies,  but  has 
been  able  at  all  times  to  save  substantial  sums  as  a  result  of  dis- 
coimting  its  bills. 

The  Waltham  Corporation  has  been  maintained,  and  is  today,  on 
a  sound  and  stable  financial  basis,  and  in  the  highest  credit  standing 
throughout  the  automobile  industry. 

He  has  lured  from  several  of  the  biggest  dividend  payers  in  the 
automobile  industry  their  most  noted  department  heads,  and  formed 
for  the  Waltham  Corporation  the  greatest  and  most  capable  corps  of 
motor  car  executives  ever  brought  together  in  one  company.  All 
these  men  are  stockholders  and  vitally  interested  in  Waltham  success. 

One  well-known  automobile  stock,  thirteen  years  ago  considered 
Uttle  better  than  a  scrap  of  paper,  is  today  valued  on  its  merits  as  a 
dividend-payer  at  more  than  $250,000  for  a  par  value  share  of  $100. 

Another  automobile  company's  1907  assets  of  $33,000  were  lifted 
by  its  guiding  genius  in  ten  years  to  its  many  millions  of  today,  and 
paid  so  many  big  dividends  that  the  average  business  man  can  scarcely 
believe  the  facts. 

If  Hinman  does  only  half  as  well  as  these  other  men  who  have 
blazed  the  way,  Waltham  stock  will  prove  to  be  a  phenomenal  money- 
m^er,  and  Waltham  stockholders  will  receive  so  many  big  dividends 


196  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

they  will  be  looked  upon  with  envy  by  those  who  have  not  been 
fortunate  enough  to  buy  Waltham  stock. 

In  pursuance  of  the  plan  that  has  helped  make  the  Waltham  Cor- 
poration the  sensation  of  the  motor  world,  he  continues,  as  heretofore, 
to  exclude  the  capitalists  and  large  investors  from  his  company  by 
declining  to  sell  more  than  $5,000  worth  of  stock  to  any  one  individual; 
but  is  now  offering  to  the  average  investor,  to  the  great  American 
pubKc,  the  opportunity  to  join  his  army  of  Waltham  "Boosters"  and 
share  with  him  the  enormous  profits  and  dividends  toward  which 
his  Company  is  so  rapidly  moving. 

His  company,  already  strongly  financed  for  all  operating  pur- 
poses, today  making  money  upon  its  operations  and  showing  a  grati- 
fying profit  upon  its  operations,  can  use  additional  capital  only  to 
erect  the  big  new  factory  buildings  planned  to  take  'care  of  the 
company's  fast-growing  business. 

Almost  1 ,600  inquiries  and  appUcations  for  Waltham  Sixes  have 
been  received  from  automobile  dealers  in  all  parts  of  the  civilized 
world  who  have  not  only  suffered  from  an  automobile  famine  the  past 
three  years,  on  account  of  the  war  destroying  Europe's  motor  industry, 
but  will,  for  a  generation,  be  unable  to  get  cars  from  any  part  of  the 
world  except  the  United  States. 

A  few  Waltham  Sixes  have  been  exported  to  various  countries,  but 
the  company  cannot  further  deprive  its  American  dealers,  and  the 
insistent  foreign  demand  must  wait  until  new  buildings  and  equipment 
can  be  provided  to  take  care  of  it. 

The  good  fortune,  which  will  be  eagerly  embraced  by  a  few 
"quick  deciders,"  to  get  a  few  shares  of  the  limited  allotment  yet  to 
be  sold,  will  so  quickly  pass  that  those  who  procrastinate  will  have 
left  only  a  vain  regret  at  a  lost  opportunity,  while  their  wiser  brothers 
are  being  started  on  the  road  to  wealth  from  a  small  investment. 

On  or  before  midnight  of  June  5,  191 7,  Waltham  stock  will 
advance  from  $14.00  to  $17.50  per  share.  Soon  afterward,  when 
the  small  allotment  for  sale  at  $17.50  to  erect  additional  factory 
buildings  has  been  sold,  the  price  will  advance  to  $20.00  per 
share,  until  funds  have  been  supplied  for  purchasing  the  necessary 
machinery,  tools,  and  equipment. 

After  that,  there  will  be  no  more  Waltham  stock  for  sale  at 
any  price. 

Many  who  will  delay  are  bound  to  be  disappointed.  The 
present  rapid  rate  of  stock  sales  will,  in  a  very  few  days,  close  out 
the  small  amount  remaining  unsold. 


MARKETING  OF  LOW-GRADE  SECURITIES  197 

Will  you  get  your  share  before  it  is  too  late  ? 

If  you  are  in  "position  to  invest  from  $500  to  $5,000,  act  quickly 
as  you  will  probably  never  have  such  another  big  money-making 
opportunity  as  long  as  you  live. 

To  avoid  disappointment,  fill  out  the  coupon  and  mail  to  us  at 
once.  We  will  then  hold  some  stock  for  you  until  you  can  visit  oui 
busy  factories,  meet  the  company's  officers  and  department  heads 
and  judge  for  yourself  whether  you  agree  with  the  Waltham  Corpo- 
ration's thousands  of  stockholders  that  this  is  the  biggest  money- 
making  opportunity  you  ever  had,  or  ever  will  have. 

Mail  this  Coupon.    It  may  start  you  on  the  Road  to  Wealth. 


Waltham  Motor  Car  Corporation, 
3550-56  Deering  Bldg., 
Chicago,  111. 

Date 

Gentlemen: 

Kindly  send  me  full  information  in  regard  to  the  Officers,  Directors, 
and  Department  Heads  of  your  Company,  its  financial  condition,  and 
why  Waltham  Motor  Stock  is  considered  a  safe  and  unusually  profit- 
able investment. 

Name 

Street  No 

City H. 


III.    BLUE  SKY  LEGISLATION 

In  an  endeavor  to  protect  investors  from  fraudulent  pro- 
motion schemes  and  to  insure  that  individuals  desiring  to 
purchase  securities  of  a  speculative  nature  shall  be  provided 
with  adequate  information  on  which  to  base  an  intelligent 
judgment,  about  forty  of  our  states  have  in  recent  years  enacted 
what  are  known  as  "blue  sky  laws."  These  laws  have  been 
directed  toward  the  supervision  of  dealers  in  securities — through 
the  installation  of  systems  of  inspection  and  through  the  exerciee' 
of  a  modicum  of  discretionary  executive  control  in  the  granting 
of  licenses  to  dealers. 

On  the  whole,  these  laws  do  not  appear  to  have  proved 
very  effective.    In  the  first  place,  they  have  in  most  cases 


198         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

attacked  the  problem  from  its  most  complex  and  difficult  end — 
that  of  regulation  after  the  securities  have  reached  the  hands 
of  the  dealers.  In  the  second  place,  the  wide  variations  in  the 
laws  of  different  states  have  afforded  many  loopholes  for  the 
sale  of  fraudulent  securities.  Stock  issued  by  a  corporation 
in  one  state  may  be  sold  in  another  state,  even  though  similar 
issues  of  corporations  organized  under  the  laws  of  such  state 
could  not  be  sold  within  its  boundaries.  For  instance,  the  law 
of  California  requires  that  before  offering  its  securities  for  sale 
a  company  must  submit  its  proposition  to  a  state  commission 
for  approval.  While  this  prevents  the  issue  and  sale  of  unsatis- 
factory securities  by  California  corporations,  it  does  not  prevent 
companies  organized  in  other  states  from  selling  their  securities 
in  California.  So  long  as  California  newspapers  will  print  the 
stock-selling  advertisements  of  companies  organized  in  other 
states,  opportunity  for  disposing  of  fraudulent  and  highly 
speculative  securities  to  the  people  of  CaUfornia  remains  practi- 
cally without  restriction. 

The  Illinois  Blue  Sky  Law  is  an  advanced  type.  The  new 
Illinois  Securities  Law,  effective  June  11, 1919,  has  gone  further 
in  the  way  of  regulation  of  the  issue  and  sale  of  investment 
securities  than  that  of  any  other  state.  It  is  to  some  extent 
modeled  after  the  English  investment  securities  legislation 
passed  many  years  ago.  The  law  is  directed  not  only  to  the 
activities  of  dealers;  it  also  supervises  the  issue  of  the  securities. 
For  the  purpose  of  the  Act,  the  securities  are  divided  into  four 
classes,  designed  to  indicate  the  degree  of  speculation  involved 
The  classification  is  as  follows: 

A.  Securities,  the  inherent  qualities  of  which  insure  their  sale  and 
disposition  without  fraud.    Within  this  group  are  included: 

1.  Securities  issued  by  a  government  or  governmental  agency 

2.  Securities  issued  by  any  national  or  state  bank  or  trust  com- 
pany, building  or  loan  association,  or  insurance  company  of 
this  state 

,  3.  Securities  issued  by  any  corporation  operating  any  public 
utility,  in  any  state  where  the  issues  of  such  utilities  are 
regulated  bv  law. 


MARKETING  OF  LOW-GRADE  SECURITIES  199 

4.  Securities  dealt  in  on  the  New  York,  Chicago,  Boston,  Balti- 
more, Philadelphia,  Pittsburgh,  or  Detroit  stock  exchanges 

5.  Securities  whose  prices  have  been  quoted  from  time  to  time  for 
at  least  a  year  in  tabulated  market  reports  published  as  news 
items,  and  not  as  advertising,  in  a  daily  newspaper  of  general 
circulation,  published  in  this  or  in  an  adjoining  state,  including 
Michigan 

6.  Securities  issued  by  any  corporation  organized  for  non- 
profit-making purposes 

B.  Securities,  where  the  inherent  qualities  are  such  or  the  nature  of 
one  or  both  parties  to  the  sale  thereof  such  that  their  sale  and 
disposition  without  fraud  is  assured.  This  comprises  the  follow- 
ing types  of  securities: 

1.  Those  sold  by  the  owner  for  the  owner's  account  exclusively, 
when  not  in  the  course  of  continued  and  repeated  transactions 
of  a  similar  nature 

2.  Increased  capital  stock  of  a  corporation,  distributed  directly 
among  its  stockholders,  without  the  payment  of  any  com- 
mission or  expense  to  agents,  brokers,  etc. 

3.  Those  sold  by  or  to  any  bank,  trust  company,  or  insurance 
company  or  association,  organized  under  the  laws  of  Illinois 
or  of  the  United  States,  or  under  the  supervision  of  the  depart- 
ment of  trade  and  conunerce  or  the  auditor  of  pubUc  accounts 
of  Illinois;  or  by  or  to  any  building  or  loan  association  of 
the  state;  or  any  public  sinking  fund,  trustees,  or  to  any 
corporation  or  any  dealer  or  broker  in  securities 

4.  Sold  or  offered  for  sale  at  any  judicial,  executors,  or  adminis- 
trators' sale  or  any  bankruptcy  or  pubUc  sale  or  auction  held 
at  any  advertised  time  or  place 

C.  Securities  based  on  an  estabhshed  income.  This  class  includes 
the  securities  issued  by  any  business  which  has  been  in  con- 
tinuous operation  not  less  than  two  years  and  which  has  shown 
net  profits,  exclusive  of  all  prior  charges,  as  follows: 

1.  One  and  one-half  times  the  annual  interest  charges  upon  all 
outstanding  interest  bearing  obligations 

2.  In  the  case  of  preferred  stock,  not  less  than  one  and  one-half 
times  the  annual  dividend 

3.  In  the  case  of  common  stock,  not  less  than  three  pier  cent  per 
annum 

D.  All  securities  not  falling  within  classes  A,  B,  and  C 


200  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  main  provisions  of  the  law  may  be  summarized  as 
follows: 

I.  Provisions  governing  the  offer  of  securities  for  sale 

Securities  in  Classes  A  and  B  are  exempt  from  the  provisions 
of  the  blue  sky  law. 

Securities  in  Class  C  may  be  sold  only  after  filing  a  sworn 
statement  in  the  office  of  the  secretary  of  state  describing  the 
securities  to  be  sold,  stating  the  law  under  which  and  the  time 
when  the  corporation  or  business  was  organized,  giving  a  balance 
sheet  of  assets  and  liabilities,  an  income  or  profit  and  loss  state- 
ment, and  an  analysis  of  the  surplus  account,  together  with  the 
names  and  addresses  of  its  principal  officers,  directors,  oi 
trustees,  and  other  pertinent  facts,  data,  and  information, 
establishing  the  character  of  such  securities.' 

Before  any  Class  D  securities  may  be  offered  for  sale,  there 
must  be  filed  in  the  office  of  the  secretary  of  state  documents 
and  statements  as  follows: 

1.  A  description  and  the  amount  of  the  securities  intended  to  be 
offered  for  sale 

2.  If  the  issuer  is  a  corporation,  a  certified  copy  of  the  charter  or 
articles  of  incorporation  and  by-laws 

3.  If  the  issuer  is  a  firm,  trust,  partnership,  or  unincorporated 
association,  a  copy  of  the  articles  of  partnership,  association, 
or  trust  agreement 

4.  The  names,  addresses,  and  prior  occupations  during  a  period 
of  not  less  than  ten  (10)  years  prior  to  filing  such  statement 
(giving  details  as  to  time,  place,  and  address  of  employer 
and  reasons  for  discontinuance  of  employment)  of  the 
officers,  directors,  or  trustees  of  the  issuer,  if  it  be  a  corpora- 
tion, or  of  the  persons  composing  the  issuer,  if  the  issuer  be 
a  non-incorporated  association 

5.  A  description  of  the  nature  of  the  industry  engaged  in  or 
intended  to  be  engaged  in  and  the  approximate  time  when 
such  industry  was  or  will  be  established 

'These  provisions  allowed  the  secretary  considerable  administrative 
latitude,  and  at  first  he  demanded  very  elaborate  and  detailed  statements, 
inventories,  and  accounts  for  qualifications.  A  great  deal  of  unnecessary 
annoyance  and  expense  resulted,  and  therefore  on  November  8,  1919, 
a  new  ruling  was  passed  which  greatly  simplified  the  requirements  by  per- 
mitting the  filing  of  sworn  summaries  instead  of  detailed  schedules.  Since 
then  public  hostility  to  the  law  has  been  greatly  diminished. 


MARKETING  OF  LOW-GRADE  SECURITIES  20I 

6.  An  inventory  showing  the  assets  of  the  issuer 

7.  An  appraisement  of  the  assets  of  the  issuer 

8.  A  statement  in  detail  of  the  gross  income  of  the  issuer  and 
the  source  or  sources  thereof  and  of  its  operating  and  other 
expenses  for  a  period  of  twelve  (12)  months  prior  to  the 
date  of  filing  such  statement,  or  for  the  period  of  the  existence 
of  the  issuer  if  less  than  two  years  prior  to  the  date  of 
filing 

9.  A  copy  of  the  most  recent  balance  sheet  of  the  issuer,  showing 
the  financial  condition  of  the  issuer  at  a  date  not  more  than 
thirty  (30)  days  prior  to  the  date  of  filing,  and  giving  an 
analysis  of  surplus  account  from  inception  of  such  issuers 

10.  A  copy  of  the  mortgage,  trust  deed,  indenture,  or  writing 
securing  the  securities,  whereunder  the  same  are  issued, 
if  any  such  instrument  there  be 

11.  A  copy  of  the  form  of  the  securities  intended  to  be  offered 

12.  A  copy  of  any  and  all  subscription  blanks  to  be  used  in  the 
sale  thereof,  which  subscription  blanks  shall  have  printed 
thereon,  "These  are  speculative  securities" 

13.  A  statement  as  to  the  manner  in  which  the  securities  are  to 
be  offered  and  sold 

At  any  time,  either  before  or  ofter  the  filing  of  such  state- 
ments, the  secretary  of  state  may  designate  certified  public 
accoimtants  to  make  examination  of  the  books,  records,  and 
documents  of  the  issuer  and  make  a  report  thereon. 

If  the  statement  discloses  that  any  of  such  securities  are 
intended  to  be  issued  for  any  patent  right,  copyright,  trade- 
mark, process,  or  good-wiU,  for  promotion  fees  or  expenses, 
or  for  other  intangible  assets,  the  amount  or  nature  thereof  should 
be  fully  set  forth  and  the  securities  issued  in  payment  therefor 
shoiild  be  delivered  in  escrow  to  a  bank  or  trust  company  desig- 
nated by  the  secretary  of  state,  under  an  escrow  agreement 
that  the  owners  of  such  seciuities  shall  in  the  case  of  dissolution 
or  insolvency  not  participate  in  the  assets  of  the  corporation 
until  after  the  owners  of  all  other  seciirities  have  been  paid  in 
full. 

In  case  any  statement  or  document  filed  in  the  office  of  the 
secretary  of  state  shall  in  his  judgment  be  inadequate  or  not  in 
compliance  with  the  act,  or  in  case  the  plan  disclosed  by  such 
documents  would  in  his  judgment  tend  to  work  a  fraud  upon 


202         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  people,  or  if  it  appears  that  the  documents  are  false  in  any 
important  particular,  the  secretary  of  state  shall  apply  for  an 
injunction  to  restrain  the  further  sale  of  such  securities. 
II.  Provisions  affecting  dealers  in  securities 

When  Class  D  securities  are  to  be  sold  through  a  solicitor, 
agent,  or  broker,  a  statement  must  be  rendered  giving  the  names, 
residences,  qualifications,  occupations,  and  business  experience 
of  such  solicitor,  agent,  or  broker  for  the  preceding  ten  years. 
The  signatures  of  each  and  every  solicitor,  agent,  or  broker 
shall  be  attached  to  such  statement. 

Any  dealer  or  owner  may  sell  Class  D  securities  only  after 
filing  in  the  office  of  the  secretary  of  state  a  statement  of  the 
amount  of  description  of  the  securities  to  be  sold  by  him,  the 
maximum  price  for  which  they  are  to  be  sold,  and  giving  his 
address  by  street  and  number,  quaUfications,  occupations,  and 
business  experience  for  the  preceding  year. 

An  irrevocable  contract  must  be  executed  by  such  solicitor, 
agent,  and  broker  authorized  to  offer  or  sell  such  securities  to 
the  effect  that  the  issuer  will  receive  in  cash  not  less  than  80 
per  cent  of  the  proceeds  of  the  sale  of  the  securities,  without 
liability  to  pay  any  further  expenses  or  commission. 

So  long  as  any  security  continues  to  be  offered  for  sale,  new 
and  supplementary  statements  must  be  filed  at  the  expiration 
of  each  six  months'  period,  showing:  (i)  the  amount  of  securities 
sold,  sale  price,  the  amount  of  cash  proceeds  received  therefore; 
(2)  all  changes  in  the  financial  conditions  of  the  issuer  or  in  its 
management  or  property,  accompanied  by  a  copy  of  the  most 
recent  balance  sheet,  which  must  be  not  more  than  thirty 
dajrs  prior  to  the  date  of  filing. 

Each  financial  statement,  prospectus,  advertisement,  etc., 
published  or  distributed  for  the  purpose  of  selling  securities 
in  Class  D  shall  contain  the  following  words  in  bold-face  type: 
"Securities  in  Class  'D'  under  Illinois  Securities  Law.  These 
are  speculative  securities."  But  it  shall  be  unlawful  to  make 
any  other  reference  to  the  fact  that  the  provisions  of  the  law 
have  been  complied  with.  Furthermore,  all  such  advertising 
literature  shall  contain  a  statement  of  the  assets,  liabilities, 
income,  and  expenses  of  the  issuer,  the  law  under  which  the  issuer 
was  incorporated  or  organized,  and  the  names  and  addresses 
of  all  officers,  directors,  and  trustees  of  the  company.    A  copy 


MARKETING  OF  LOW-GRADE  SECURITIES  203 

of  such  financial  prospectus,  etc.,  shall  be  filed  in  the  office  of 
the  secretary  of  state  within  ten  days  after  the  first  circulation, 
publication,  or  distribution.  It  shall  be  unlawful  to  publish 
or  circulate  therewith  a  statement  of  the  earnings  of  other  com- 
panies engaged  in  a  similar  business. 

Under  a  recent  rvding  by  the  secretary  of  state,  dealers  may 
offer  and  provisionally  sell  all  classes  of  securities  before  they 
have  been  accepted  by  the  secretary  as  properly  qualified, 
actual  delivery  of  the  securities  themselves  not  being  made 
until  after  qualification.' 

m.  Penalties 

The  penalties  attached  to  the  Act  are  severe.  Attempts 
to  sell  securities  without  full  compliance  with  the  provisions  of 
the  Act  are  punishable,  in  the  case  of  dealers,  with  fines  as 
high  as  $10,000,  or  one  year's  imprisoimient,  or  both;  and  for 
sale  of  securities  in  case  the  issuer  is  known  to  be  insolvent, 
when  the  purchaser  loses  by  such  sale,  $10,000,  or  five  years, 
or  both.  In  addition,  dealers  who  sell  in  violation  of  any 
provision  are  liable  for  the  full  purchase  price  to  the  purchaser, 
plus  reasonable .  attorney's  fees;  and  for  misrepresentation  of 
the  facts  contained  in  the  filed  statements,  "to  a  maximum  fine 
of  $s,ooo  or  one  year's  imprisonment,  or  both." 

Two  main  questions  present  themselves  in  connection  with 
this  comprehensive  law.  First,  is  it  adequate  to  prevent  mis- 
representation and  fraud  ?  Second,  does  it  impose  undue  burdens 
on  the  development  and  conduct  of  business  ? 

The  law  does  not  reach  certain  important  evils.  With  reference 
to  the  first  question,  the  general  conclusion  appears  to  be  that 
the  law  is  effective  as  far  as  it  goes;  but  that  it  completely  fails 
to  reach  various  classes  of  operations — ^among  which  are  some 
of  the  most  important  that  such  a  law  is  designed  to  control. 
In  the  regulation  of  reputable  dealers  in  securities,  it  appears  to 
be  successful  enough;  but  in  the  regulation  of  dealers  who  are 
of  questionable  character,  it  has  thus  far  made  but  little  progress. 

*  The  necessity  and  justice  of  this  ruling  is  obvious.  The  process  of 
qualification  is  often  long,  and  if  the  dealers  have  to  wait  during  this  period 
before  they  can  solicit  purchases,  the  securities  will  be  moved  to  some  other 
part  of  the  country  where  they  can  find  a  quicker  market;  and  profit 
that  should  normally  accrue  to  Uie  Illinois  dealers  will  be  lost  to  them. 


204         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  same  holds  true  for  the  marketing  of  such  securities. 
The  two  agencies  by  which  doubtful  securities  are  most  com- 
monly disposed  of — advertising  and  direct  correspondence — 
do  not  in  fact  come  under  its  jurisdiction  at  all.  In  the  latter 
case,  the  federal  government  exercises  some  control;  and  in  the 
former,  efforts  have  been  made  to  enUst  the  Chicago  news- 
papers against  the  acceptance  of  spurious  advertisements;  but 
the  effect  upon  the  general  situation  has  not  been  great.  Fin- 
ally, in  the  case  of  doubtful  securities  handled  through  Illinois 
dealers,  and  especially  of  securities  issued  by  corporations  of 
other  states,  there  is  to  date  absolutely  no  means  of  insuring 
the  detection  of  non-compliance  with  the  law,  or  of  failure  to 
file  and  qualify  before  sale.  This  is  perhaps  the  greatest  single 
weakness  that  has  appeared  in  the  Illinois  law;^  it  is  one  which 
is  common,  moreover,  to  nearly  all  the  blue  sky  legislation  of 
the  present. 

The  law  handicaps  legitimate  Illitwis  dealers.  With  reference 
to  the  second  question,  the  restrictions  it  places  upon  the 
development  of  new  enterprises  are  probably  not  great,  although 
it  is  too  soon  to  be  sure.  A  bona  fide  concern  can  qualify 
its  securities  imder  the  law  without  much  diflficulty;  and  the 
slight  handicap  here  is  more  than  compensated  for  by  the  par- 
tial suppression  of  fraudulent  enterprises.  But  upon  the  con- 
duct of  established  banking  and  brokerage  businesses  in  Illinois 
the  law  has  already  had  some  ill  effects.  Because  of  the  red 
tape,  expense,  and  delay  involved,  it  is  operating  to  drive 
securities  away  from  Illinois  markets,  for  the  issuers  find  it  less 
costly  to  sell  their  securities,  by  mail,  in  other  states.  More- 
over, by  requiring  the  dealer  to  pay  his  fees  and  undergo  the 
expense  of  qualification  before  any  sale  can  be  made,  the  law, 
in  the  case  of  the  smaller  issues,  frequently  wipes  out  prac- 
tically all  profit.  Because  of  this,  various  New  York  bankers 
have  already  shifted  a  considerable  portion  of  their  business 
from  the  western  to  the  eastern  markets.  Moreover,  the 
delays  incident  to  qualification  often  make  it  impossible  for 
dealers  to  take  advantage  of  a  sudden  favorable  turn  of  the 
market. 


MARKETING  OF  LOW-GRADE  SECURITIES  20$ 

It  is  of  interest  to  note  that  under  the  working  of  the 
Illinois  law  in  the  first  twelve  months  of  its  existence,  a  great 
many  applications  for  permission  to  sell  securities  in  Illinois 
were  denied.  Out  of  a  total  of  519  applications  to  sell  securities 
in  Illinois,  208  were  disapproved,  the  sums  involved  totaling 
$66,917,410,  of  which  $57,636,840  was  in  Class  D  and  the 
remainder  in  Class  C. 

IV.    SUGGESTED  CONTROL  OVER  THE  FORMATION 
OF  CORPORATIONS 

The  experience  up  to  date  under  the  new  Illinois  Securities 
Law,  and  with  blue  sky  legislation  in  general,  raises  the  funda- 
mental question,  Is  this  the  right  way  to  attack  the  problem  ? 
The  Committee  on  Legislation  of  the  Investment  Bankers' 
Association  of  America  has  issued  the  following  statement:- 

To  the  present  time  such  acts  as  have  been  passed  and  put  into 
effect  have  been  fundamentally  wrong  in  the  way  they  sought  to 
go  about  solving  the  problem The  theory  of  licensing  repu- 
table dealers  in  investment  securities  haS  proved  to  be  worse  than 
useless,  in  that  reputable  people  do  not  need  to  be  controlled,  and 
....  a  person  already  violating  the  law,  and  subject  to  criminal 
prosecution  will  not  be  deterred  from  his  ways  by  the  placing  of  one 
or  more  additional  statutes  on  the  books.' 

There  is  undoubtedly  much  truth  in  this  statement.  Even 
the  very  comprehensive  Illinois  law,  as  we  have  seen,  completely 
misses  a  large  field  in  which  misrepresentation  and  fraud  are 
common,  while  at  the  same  time  it  imposes  heavy  burdens  on 
another  field  which  is  normally  free  from  questionable  practices. 
And  with  the  exception  of  the  Illinois  law,  blue  sky  legislation 
has  applied  only  to  the  sale  of  securities  already  issued.  The 
question  is  therefore  pertinent.  Is  not  the  only  effective  form  of 
control  that  which  is  imposed  at  the  source — which  actively 
governs,  as  none  of  our  laws  now  do,  both  the  actual  issu- 
ing of  the  securities  and  the  formation  of   the  corporations 

*  Investment  Bankers'  Association  of  America  Bulletin,  Vol.  VIII  (De- 
pember  10, 1919),  125-30. 


2o6         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

themselves  ?  If  so,  a  federal  law,  or  uniform  state  laws,  wouU 
have  to  be  devised  on  lines  radically  different  from  any 
now  in  existence,  providing  comprehensive  administrative 
machinery  and  conveying  wide  discretionary  powers  to  a 
responsible  executive  department. 

With  reference  to  federal  control,  it  may  be  noted  that  some 
federal  experience  in  this  field  was  gained  during  the  war. 
Because  of  the  necessity  of  disposing  of  great  quantities  of 
Liberty  Bonds,  it  became  necessary  to  restrict  the  issue  and 
sale  of  securities  to  corporations  which  were  essential  to  the 
winning  of  the  war.  There  was  accordingly  organized  in  the 
Treasury  Department  a  Capital  Issues  Committee,  which  passed 
upon  all  applications  for  new  financing.  This  committee  was 
demobilized  shortly  after  the  armistice,  along  with  the  rest  of 
our  war  machinery.  Nmnerous  suggestions  have  since  been 
made,  however,  that  such  a  committee  be  organized  as  a  per- 
manent part  of  the  machinery  of  federal  regulation.  And  a 
bill  for  a  national  blue  sky  law  was  introduced  in  Congress  by 
Representative  Volstead  in  January,  1920.  This  bill,  which 
has  been  approved  by  the  Legislative  Committee  of  the  Invest- 
ment Bankers'  Association,  provides  for  placing  the  supervision 
of  securities'  sales  in  the  hands  of  the  Attorney-General  and 
gives  him  considerable  discretionary  power.  The  aim  of  the 
proposed  law  is  not  to  handicap  legitimate  trading,  but  to  pre- 
vent the  issue  of  fraudulent  securities. 

Control  of  the  issue  of  securities  should  not  prohibit  new  finan- 
cing. The  suggestion  that  both  the  formation  of  the  corpora- 
tions and  the  actual  issuing  of  securities  be  subjected  to  effective 
control  raises,  however,  another  fundamental  question.  If 
new  industries  are  to  be  developed,  they  must  be  enabled  to 
secure  capital  through  the  issue  and  sale  of  securities.  Free- 
dom from  legal  restriction  in  the  issue  of  securities  has,  as  we 
have  seen,  given  rise  to  very  grave  abuses  and  heavy  financial 
loss  to  nearly  all  classes  of  people.  But  it  has  left  the  door  open 
for  the  financing  of  new,  and  hence  uncertain  and  speculative, 
industries;  it  has  in  many  ways  facilitated  our  industrial 
progress.    In   endeavoring   to   protect    the   investing   public 


MARKETING  OF  LOW-GRADE  SECURITIES  207 

from  fraudulent  securities,  we  should  not  go  so  far  as  to  prevent 
entirely  the  marketing  of  speculative  issues;  on  the  contrary, 
we  must  permit  the  ready  financing  of  new  enterprise  or  become 
industrially  stagnant. 

If  we  are  to  do  more  than  guard  against  fraud  in  the  market- 
ing of  securities,  and  furnish  the  necessary  information  on  which 
an  intelligent  investor  can  form  a  reasonably  sound  judgment — 
if  we  are  to  go  back  of  the  selling  process  and  place  in  the  hands 
of  government  officials  the  power  to  veto  an  honest  issue  of 
securities,  merely  on  the  ground  that  such  an  issue  would 
be  highly  speculative,  we  should  be  lodging  with  government 
officials  a  substantial  control  in  directing  our  industrial  develop- 
ment. Or  if  we  refuse  to  permit  any  securities  to  be  issued 
for  public  sale  until  the  issuing  corporation  has  proved  successful 
over  a  period  of  years,  we  compel  a  corporation  to  pass  its 
novitiate  either  as  a  partnership  or  as  a  closed  corporation  where 
the  funds  are  derived  entirely  from  a  small  group  of  interested 
investors. 

AH  things  considered,  it  is  doubtless  wise  to  attempt  a  more 
rigid  control  over  the  formation  of  new  corporations;  for  it  is 
conceivable  that  such  control  may  be  so  safeguarded  that  only 
good  would  result  from  its  inauguration.  It  would  seem  that 
two  results,  at  least,  might  reasonably  be  achieved.  On  the 
one  hand,  a  plan  might  well  be  devised  that  would  shift  the 
risks  of  starting  and  financing  new  enterprises  to  the  classes 
which  can  best  afford  to  bear  the  risks;  namely,  the  larger 
private  investors  and  capitalists,  rather  than  the  rank  and 
file  of  small  investors.  On  the  other  hand,  the  promotion 
business  should  be  made  improfitable;  indeed,  it  should  be 
made  impossible  for  men  to  float  new  schemes,  take  their 
profits  out  of  the  promotion  process,  and  then  sell  out, 
leaving  the  enterprise  to  work  out  its  own  salvation,  as  best 
it  may. 

This  is  not  the  place,  however,  either  to  attempt  a  formula- 
tion of  the  details  of  securities  legislation  or  to  reach  any 
final  judgment  on  the  whole  question  of  blue  sky  regulation. 
It  will  be  sufficient  if  the  foregoing  consideration  of  the  nature 


2oS         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

of  the  promotion  business,  and  the  difficulties  that  have  been 
encountered  in  connection  with  blue  sky  legislation  make  it 
clear  that  we  still, have  before  us  some  very  baffling  problems 
in  regulating  the  issue  and  sale  of  low-grade  securities.' 

QUESTIONS  FOR  DISCUSSION 

1.  What  is  meant  by  low-grade  securities?  Might  bonds  ever  be 
included  ? 

2.  What  are  some  of  the  principal  types  of  low-grade  securities? 
Classify  them  by  different  branches  of  industry. 

3.  Examine  the  quotations  of  securities  on  the  New  York  and  Chi- 
cago stock  exchanges.  Do  you  find  among  the  shares  there 
traded  in  any  belonging  to  (o)  the  industrial  group?  (b)  the 
mining  group?  (c)  the  automobile  group?  (J)  the  oil  group? 
Are  the  issues  of  these  companies  low  grade? 

4.  Examine  the  quotations  of  securities  on  the  New  York  curb 
Are  all  of  these  highly  speculative  low-grade  issues? 

5.  Do  you  imagine  that  all  of  the  oil  and  mining  companies  whose 
stocks  are  daily  being  bought  and  sold  are  fraudulent  or  worthless 
concerns  ? 

6.  May  low-grade  securities  in  time  become  high-grade  securities? 
If  so,  under  what  circumstances?  Would  it  have  been  a  good 
thing  to  have  prevented  the  raising  of  capital  for  such  enterprises  ? 

7.  What  classes  of  people  are  most  frequently  besought  to  buy 
low-grade  securities  ?  What  classes  of  people  take  the  greatest 
risk  when  buying  such  securities  ?  What  classes  of  people  can 
least  afford  to  buy  highly  speculative  securities  ? 

8.  What  ways  are  available  to  newly  organized  corp)orations  for 
raising  the  capital  required?  Which  way  would  you  adopt? 
Under  all  circumstances  ? 

9.  Do  you  think  it  is  necessary  to  protect  the  people  from  invest- 
ing their  funds  in  such  schemes  as  those  promoted  by  George 
Underbill  ? 

10.  Judging  by  the  number  of  oil  and  mining  companies  that  have 
been  organized  since  the  Great  War,  do  you  think  investment 
knowledge  has  advanced  much  since  the  time  of  the  South  Sea 
Bubble? 

'For  this  material  on  securities'  regulation  the  author  has  drawn 
heavily  upon  a  paper  prepared  by  one  of  his  students,  Mr.  J.  W.  Angell. 
Much  of  the  phraseology,  even,  has  been  borrowed.  See  Journal  of  Politi- 
cal Economy,  April,  1919,  pp.  307-21. 


MARKETING  OF  LOW-GRADE  SECURITIES  209 

11.  Is  the  post-war  speculative  craze  attributable  to  any  lack  of 
conservative  investment  opportunities  ? 

12.  Do  you  think  the  Ranger-Texas  Oil  Company  has  any  pKJSsibility 
of  proving  successful  ? 

13.  What  ways  are  available  for  preventing  fraud  in  the  promotion 
of  new  companies  ? 

14.  Why  is  it  so  difficult  to  apprehend  and  punish  the  guilty  parties  ? 

15.  What  features  of  the  advertisement  of  the  Waltham  Motor  Car 
Corporation  appear  suspicious  to  you?  Do  these  features 
necessarily  prove  the  issue  of  doubtful  value  ? 

16.  Do  you  think  any  of  the  provisions  governing  the  issues  of 
securities  in  Class  C,  under  the  Illinois  Securities  Law,  are  vinduly 
onerous  ? 

17.  Do  you  regard  any  of  the  provisions  governing  the  issue  of  Class  D 
securities  as  unduly  severe  ? 

18.  Under  the  Illinois  Securities  Law,  as  it  stands,  would  it  be  possible 
to  raise  capital  for  a  new  concern  by  the  sale  of  securities  to  the 
general  public  ? 

19.  Can  a  concern  furnish  a  balance  sheet  and  an  income  statement 
if  it  is  not  already  a  going  concern  ? 

20.  Do  you  favor  the  abolition  of  all  promotion? 

21.  "All  that  the  state  can  hope  to  do  is  to  prevent  fraud  in  the  selling 
of  securities  and  to  see  to  it  that  only  reliable  parties  engage 
either  in  the  issue  or  sale  of  securities."    Do  you  agree  ? 

22.  "All  agree  that  the  solicited  investor  should  not  be  permitted  to 
buy  blindly,  even  if  he  is  wiUing  to  do  so.  But  should  we  go 
further  ?  Should  the  state  administrator  say  '  this  is  an  unsound 
venture;  finance  it  privately,  if  you  can,  but  you  cannot  finance 
it  by  a  general  solicitation  or  offering'  ?  In  the  answer  to  this 
question  lies  the  fundamental  diversity  of  opinion  among  the 
advocates  of  blue  sky  legislation."  What  is  your  opinion  on 
the  subject  ? 

23.  "When  a  company  applies  for  a  charter,  it  should  be  the  duty 
of  the  state  to  ascertain  whether  the  individuals  who  are  organiz- 
ing the  concern  are  men  of  ability  and  integrity,  and  whether 
the  company  has  any  possibility  of  success."  How  Could  the 
state  know  whether  a  concern  had  any  possibility  of  success  ? 

24.  "We  cannot  afford  to  make  either  our  corporation  laws  or  the 
regulations  governing  the  issue  and  sale  of  securities  so  strict 
that  the  raising  of  capital  for  new  concerns  in  established  lines 


iio         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

of  industry,  or  for  concerns  in  new  lines  of  industry,  is  rendered 
impossible,  or  is  seriously  hampered."  Do  you  agree  ? 
25.  "Newly  organized  corporations  should  be  required  tb  raise  the 
capital  necessary  for  making  the  enterprise  a  going  concern 
without  offering  the  securities  to  the  general  public;  or  if  offered 
to  the  general  public,  subscriptions  should  not  be  taken  for  less 
than  a  minimum,  say,  of  $1,000,  in  order  to  insure  that  only 
people  of  some  means  and  some  ability  in  judging  values  shall 
risk  their  funds  in  the  enterprise.**    Do  you  agree  ? 

REFERENCES  FOR  FURTHER  READING 
Reed  and  Washburn :  Blue  Sky  Laws. 


CHAPTER  XIV 

THE  MARKETING  OF  HIGH-GRADE 
SECURITIES 

The  marketing  of  high-grade  securities,  such  as  those 
enumerated  in  Classes  A  and  B  under  the  Illinois  Securities 
Act,'  is  largely  effected  nowadays  through  the  intermediation 
of  financial  houses  called  investment  banking  institutions. 
At  the  present  time  the  principal  sources  of  demand  for  invest- 
ment funds  are:  first,  the  raising  of  capital  for  business  enter- 
prises; second,  the  needs  of  governments,  national,  state,  and 
local;  and  third,  the  purchase  and  improvement  of  real  estate. 
All  these  sources  of  demand  have  increased  tremendously  in  the 
last  half-century;  and  it  is  this  fact,  together  with  the  develop- 
ment of  the  corporate  form  of  organization,  that  has  forced  the 
development  of  the  elaborate  investment  banking  machinery 
of  the  present  day. 

The  securities  that  are  marketed  by  these  financial  institu- 
tions include  the  issues  of  railroad,  public  utility,  industrial, 
and  other  corporations,  and  of  federal,  state,  city,  county, 
township,  and  other  local  government  bodies.  Real  estate 
issues  are  usually  not  marketed  through  the  regular  investment 
channels.*  The  types  of  securities  handled  now  comprise 
stocks,  bonds,  and  short-term  notes;  although  until  recently 
bonds  have  occupied  a  dominant  position  in  the  investment 
market.  Some  houses  specialize  in  the  marketing  of  bonds; 
some  are  mainly  concerned  with  issues  of  high-grade  stock, 
common  as  well  as  preferred;  whUe  others  handle  both  bonds 
and  stock.  In  general  the  drift  appears  to  be  away  from  narrow 
specialization,  with  the  emphasis,  however,  always  upon  con- 
servative, as  distinguished  from  speculative,  securities. 

■  See  classification  on  pp.  198-99  above. 

»  For  a  discussion  of  the  marketing  of  real  estate  bonds  and  mortgages 
see  chap,  xxvi  below. 


2ia         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

I.    HISTORY  OF  INVESTMENT  BANKING 

The  investment  banking  institutions,  with  their  various 
functions  of  investigation,  underwriting,  and  marketing  securi- 
ties, are  of  comparatively  recent  development,  their  history 
running  parallel  with  that  of  the  corporate  form  of  industry, 
outlined  in  chapter  xi.  Investment  financiers,  however,  have 
existed  for  many  centuries.  In  medieval  times  kings  and 
governments  received  their  revenues,  as  now,  largely  from 
taxes.  Since  the  need  for  funds  was  practically  continuous, 
while  the  taxes  were  received  only  intermittently,  there  devel- 
oped the  practice  of  securing  "advances"  from  powerful 
financiers,  to  whom  the  collecting  of  the  taxes  was  "farmed 
out "  as  security  for  the  loan.  The  financial  needs  of  the  various 
European  rulers  were  at  times  so  great  that  the  financiers  to 
whom  they  looked  for  aid  came  practically  to  dominate  the 
poUtical  as  well  as  the  financial  life  of  Europe.  Where  the 
"tax  security"  was  insufficient,  valuable  property  was  some- 
times mortgaged  to  the  financiers.  For  instance,  in  1487 
Jacob  Fugger,  having  grown  tremendously  wealthy  through 
operations  in  trStding,  mining,  and  banking,  received  the  rich 
mines  of  Tyrol  as  a  guaranty  for  the  payment  of  a  loan  to 
Duke  Sigismund.  This  was  followed  by  large  loans  to  Sigis- 
mund's  successor,  Maximilian,  and  to  Pope  Julius  11;  while 
after  the  death  of  Maximilian,  Charles  V  succeeded  in  becoming 
Roman  emperor  by  the  purchase  of  electors  on  funds  borrowed 
from  "  the  Fuggers."  By  1524  the  Fuggers  had  assumed  control 
of  a  large  part  of  the  Spanish  land  taxes  and  mines;  they  had 
estd,blishments  in  Poland,  Hungary,  Antwerp,  and  Naples; 
and  their  operations  and  power  extended  from  Belgium  to  India. 

Before  the  Civil  War  there  was  little  investment  hanking  in  the 
United  States.  From  colonial  days  until  the  Civil  War  period, 
in  our  own  history,  most  businesses  were  conducted  on  the 
individual  or  partnership  basis,  with  the  funds  furnished  directly 
by  those  immediately  interested  in  the  enterprises.  During  this 
period  the  financial  dealings  of  governments  were  also  relatively 
unimportant,  except  in  times  of  war.  The  Revolutionary  War, 
however,  was  financed  largely  by  the  issue  of  paper  currency; 


MARKETING  OF  fflGH-GRADE  SECURITIES  213 

and  the  War  of  181 2  did  not  involve  any  extensive  bond-selling 
campaign.  Not  until  the  Civil  War  did  the  issue  of  securities 
by  the  federal  government  become  important.  Even  then 
the  government  securities  were  largely  sold  direct  to  banking 
institutions  and  individuals  of  means,  rather  than  to  the  general 
investing  public;  so  that  the  market  mechanism  involved 
was  relatively  simple. 

In  these  early  days  demands  for  a  large  aggregation  of 
capital  came  principally  in  connection  with  the  development  of 
public  highways,  rivers,  canals,  railroads,  banking,  and  insur- 
ance. The  financing  of  public  works  and  railroads  was  effected 
partly  through  loans  from  banking  institutions — often  directly 
affliated  with  the  enterprise — and  partly  by  the  issue  and  sale 
of  securities  to  the  investing  public.  The  funds  were  generally 
obtained  for  these  early  corporations  from  local  investors, 
principally  of  the  merchant  class,  "ranging  from  the  small 
country  storekeeper  to  the  wealthy  metropolitan  merchant 
importer;  there  were  others,  however,  as  well:  retired  farmers 
or  merchants;  widows  of  substance;  children  who  had  inherited 
well;  landed  proprietors  who  had  picked  up  public  securities; 
successful  speculators  in  stocks;  and  a  considerable  body  of 
small  savers  in  town  and  country."* 

In  numerous  cases  funds  were  also  secured  from  outside 
the  locality — principally  in  financial  centers  such  as  New  York, 
Boston,  and  Philadelphia,  and  in  foreign  countries.  Before 
1800,  state  subscriptions  were  important  elements  only  in  the 
larger  Virginia  canals  and  the  early  New  York  canals,  and  in  the 
Bank  of  North  America,  the  United  States  Bank,  the  Union 
Bank  of  Boston,  and  the  Bank  of  Pennsylvania.  Occasionally 
towns  took  a  stake  in  bridge  or  canal  companies,  but  rarely,  if 
ever  to  any  large  extent.*  In  the  twenties  and  thirties,  however, 
state  assistance  played  a  leading  role  in  the  development  of 
public  works. 

From  the  beginning  some  capital  has  also  been  drawn  from 
abroad.     In  the  colonial  period  a  considerable  volume  of  fimds 

'  Davis,  Essays  in  Early  History  of  American  Corporations,  IV,  279-302. 
'Ibid. 


214         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

was  annually  brought  in  by  immigrants  and  there  were  some 
loans  to  this  coimtry  by  European  capitalists.  It  was  not  until 
after  1825,  however,  that  European  purchasers  of  American 
securities  became  important.  In  that  year  nine  issues  of 
government  bonds  and  a  number  of  state  and  city  bonds  were 
quoted  on  the  London  Stock  Exchange.  In  the  construction  era 
of  the  thirties,  a  large  volume  of  foreign  capital  sought  invest- 
ment in  this  country,  the  total  being  estimated  in  1839  at 
$200,000,000.  The  railroad  developments  of  the  forties  and 
fifties  induced  additional  foreign  investments,  the  first  railway 
loan  floated  in  London  being  a  $2,000,000  issue  of  the  Baltimore 
and  Ohio  road,  brought  out  by  Baring  Brothers  in  1846.  The 
Civil  War  halted  developments;  but  in  1866  the  total  of 
British  and  French  capital  in  this  country  was  estimated  at 
$350,000,000,  while  by  1869  it  had  increased  to  a  billion.  In 
that  year  David  A.  Wells  estimated  the  total  of  all  foreign 
investments  in  the  United  States  at  $1,465,000,000;  while  in 
1910  Sir  George  Paish.  placed  the  amount  at  $6,500,000,000. 

In  the  period  before  the  Civil  War,  the  domestic  invest- 
ment market  was  a  very  simple  afl[air.  The  bulk  of  the  invest- 
ments were  made  directly — without  the  intermediation  of  any 
significant  banking  machinery.  Local  banks,  it  is  true,  often 
assisted  in  bringing  borrower  and  lender  together  and  mortgage 
companies  were  developing  for  the  purpose  of  facilitating  the 
making  of  agricultural  loans.  But  it  was  not  until  after  the 
Civil  War  period  that  investment  banking  institutions  assumed 
an  important  position  in  our  financial  system.  Indeed,  it  was 
not  until  the  turn  of  the  century  that  investment  banking 
really  came  into  its  own. 

n.    MODERN  INVESTMENT  BANKING 
DEVELOPMENT 

The  investment  banking  business,  as  we  now  know  it, 
appears  to  have  originated  in  connection  with  the  issues  of 
municipal  subdivisions — cities,  counties,  townships,  etc.  In 
the  early  days  of  this  investment  business,  municipal  bond 


MARKETING  OF  HIGH-GRADE  SECURITIES  215 

issues  were  first  disposed  of  almost  entirely  in  the  local  market 
through  the  aid  of  local  banks,  who  engaged  in  the  bond  business 
as  a  side-issue  to  their  regular  banking  operations.  But  as 
the  issues  increased  in  volume,  the  local  banker  was  forced  to 
seek  outside  sources  of  funds.  He  was  handicapped  in  his 
operations,  however,  because  securities  were  floated  only 
periodically  and  his  bond-selling  was  therefore  but  an  inter- 
mittent activity.  Specialization  in  investments,  with  a  large 
variety  of  offerings,  and  a  regular  clientele  were  necessary  to 
an  effective  organization  of  the  business. 

It  was  the  custom  in  the  early  days  for  municipalities  to 
sell  their  bonds  privately  and  without  public  advertisement. 
Accordingly,  as  the  business  grew  and  as  energetic  specialists 
entered  the  field  of  investment,  buyers  were  sent  about  the 
country  to  locate  new  issues  and  effect  as  advantageous  a 
purchase  as  possible.  Finally,  as  the  numbers  of  buyers  in- 
creased and  competition  became  keener,  the  practice  of  adver- 
tising bond  issues  at  public  sale  developed,  with  the  result 
that  several  buyers  would  appear  at  each  sale  and  make 
competitive  bids  for  the  privilege  of  disposing  of  the  issue. 
This  practice  greatly  improved  the  market  for  securities  and 
placed  the  business  upon  a  much  more  efficient  and  econom- 
ical basis. 

In  a  similar  way  the  distribution  end  of  the  business  was 
broadened.  So  long  as  investors  were  relatively  few  in  number 
and  composed  mainly  of  well-to-do  business  men,  insurance 
companies,  and  savings  banks,  bond  dealers  usually  foimd 
it  possible  to  distribute  the  larger  portion  of  their  bond  issues 
directly  over  the  counter,  and  the  remainder  by  correspondence. 
But  as  the  volume  of  securities  offered  for  sale  increased,  it 
became  necessary  to  extend  the  field  of  distribution,  and  sales- 
men were  employed  to  secure  new  customers,  both  locally  and 
in  other  communities,  as  well  as  to  keep  closely  in  touch  with 
the  existing  clientele. 

There  are  many  specialized  investment  banks.  With  the 
development  of  large-scale- corporate  industry  and  the  extension 
of  the  investment  banking  field  to  include  railroad,  public 


2l6         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Utility,  and  industrial  securities  of  every  description,  there 
developed  specialized  investment  institutions.  Some  bond 
houses  devote  themselves  almost  exclusively  to  the  marketing 
of  municipal  securities;  others  specialize  in  the  financing  of 
steam  railroads;  still  others  are  concerned  only  with  public 
utility  financings — and  there  is  specialization  even  within  this 
field,  for  instance,  in  the  securities  of  gas  or  electric  light  com- 
panies, power  corporations,  or  street  railways.  In  recent  years, 
certain  houses  are  specializing  in  industrial  securities. 

It  is  not  to  be  understood  that  such  specialization  means  an 
exclusive  dealing  in  a  particular  type  of  security.  An  invest- 
ment house  specializing  in  railroad  securities  may  also  buy 
and  sell  or  trade  other  securities  to  a  limited  extent,  for  the 
convenience  of  its  regular  customers.  Houses  do  this,  how- 
ever, in  the  capacity  of  brokers,  or  as  a  result  of  an  ex- 
change of  seciuities  with  other  houses,  rather  than  in  the 
capacity  of  financial  adviser  and  underwriter  for  the  issuing 
corporations. 

There  are  houses,  also,  which  sometimes  combine  the  work 
of  engineering  and  operating  establishments  with  the  function 
of  financing. 

Though  such  organizations  are  not  numerous,  they  are  impor- 
tant. By  reason  of  special  skill  and  ability  in  their  chosen  fields 
they  have  effected  economies  in  operation  and  construction.  They 
purchase  plants  which  have  not  proved  profitable  under  the  exist- 
ing management  and  through  their  special  skill  turn  them  into  profit- 
able enterprises.  Through  the  magnitude  of  their  operations  they 
can  also  effect  economies  in  the  purchase  of  supplies.  Such 
engineering-banking  organizations  specialize  in  the  field  of  public 
utilities  more  than  do  bankers  who  are  not  also  engineers.  A  house 
of  engineering  bankers  confines  itself  to  gas  plants  or  to  electric- 
light  properties  or  to  street  railways.' 

With  the  exception  of  a  few  lines  of  business,  notably 
banking,  and  of  relatively  small  corporations,  the  issues  of 
which  are  sold  directly  to  members  of  a  family  or  to  a  small 

'  Lyon,  Corporation  Finanu,  U,  40. 


MARKETING  OF  mCH-GRADE  SECURITIES  217 

group  of  "inside  stockholders,"  most  corporations  seek  the 
aid  of  investment  bankers  in  raising  capital.  As  will  presently 
be  seen,  it  is  an  admirable  division  of  labor  for  the  raising  of 
funds  to  be  turned  over  to  specialized  institutions  that  are 
well  equipped  for  the  purpose  in  hand. 

For  some  lines  of  industry,  however,  adequate  investment 
banking  machinery  has  not  as  yet  been  developed.  Municipal, 
railroad,  public  utility,  and  the  larger  industrial  enterprises 
have  little  difiSculty  in  securing  capital  through  investment 
bankers.  But  in  the  case  of  the  smaller  industrial  concerns, 
the  machinery,  though  rapidly  improving,  is  still  inadequate. 
The  cost  of  investigation  and  of  advertising,  in  order  to  make  a 
little-known  enterprise  sufficiently  popular  to  attract  investors, 
is  often  disproportionate  to  the  amount  of  capital  required. 
The  banker  would  thus  have  to  charge  so  much  for  his  services 
that  it  would  impose  a  very  heavy  burden  upon  the  business. 
This  is  one  of  the  reasons  why  the  smaller  industrial  concerns 
have  had  to  raise  their  funds  through  promotion  schemes,  as 
outUned  in  the  previous  chapter. 

in.    FUNCTIONS  OF  INVESTMENT  BANKING 
INSTITUTIONS 

The  terminology  that  is  commonly  employed  in  speaking 
of  the  work  of  investment  banking  institutions  is  somewhat 
confusing.  Some  writers  speak  of  houses  of  first  purchase,  of 
underwriters,  and  of  distributing  bond  houses  in  a  way  that 
would  lead  one  to  believe  that  they  are  distinct  and  specialized 
institutions,  each  performing  a  particular  task  and  that  only. 
If  a  clear  view  of  the  work  of  investment  banks  is  to  be  gained, 
it  will  be  necessary  to  make  a  classification  that  runs  in  terms 
of  functions  rather  than  in  terms  of  institutions.  The  diagram 
on  page  218  attempts  to  set  forth  the  several  functions  that 
are  performed  by  investment  banks. 

In  brief,  the  function  of  investigation  and  analysis  is  to 
determine  whether  a  proposed  bond  issue  has  sufficient  merit 
to  be  offered  to  a  conservative  investing  public.  It  is  the 
fimction  of  underwriting  to  assmne  the  risks  that  inhere  in 


2i8         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


the  raising  of  the  funds  required  and  insure  the  corporation 
that  it  shall  have  its  funds  on  a  specified  date,  whether  or  not 
the  securities  have  been  sold  to  the  investing  public.  It  is 
the  fiinction  of  distribution  to  sell  an  issue  of  securities  to 
investors.    All  of  these  functions  may  be,  and  usually  are, 


THE  CORPORATION 

Issues  Stocks,  Bonds,  and  Short-tenn  Notes 


FUNCTION  OF  INVESTIGATION 
AND  AN^SIS 

^Oai^^E«^RITi 


FUN( 


riNG 


FUNCTION  OF  DISTRIBUTION 


Individiial 
Purchaaer 


Business 
ConcemI 


Fraternal  Orders, 
Clubs,  etc 


Insurance 
Companies 


Trade 
Unions 


Savings 
Banks 


Commercial 
Banks 


Eleemosynary 
Institutions 


Trust 
EitatM 


performed  by  a  single  institution,  although  there  is  some  degree 
of  specialization  by  investment  bankers.  Such  concerns,  for 
instance,  as  Morgan  &  Co.,  are  chiefly  interested  in  original 
investigation  and  in  underwriting,  while,  on  the  other  hand, 
there  are  many  small  bond  houses  whose  activities  are  mainly 
confined  to  the  retail  marketing  of  securities. 


IV.    INVESTIGATION  AND  ANALYSIS 

The  original  investigation  and  analysis  of  an  issue  of 
securities  may  be  undertaken  by  any  investment  banker, 
large  or  small.    There  are  a  great  many  relatively  small  issues 


MARKETING  OF  HIGH-GRADE  SECURITIES  219 

of  securities  put  out  by  medium-sized  concerns  that  are  handled 
by  small  and  inconspicuous  investment  bankers.  In  the  case 
of  very  large  issues,  however,  there  are  a  few  great  financial 
houses  which  now  more  or  less  occupy  the  field.  As  we  shall 
presently  see,  this  is  mainly  because  the  underwriting  of  such 
issues  requires  very  large  resources. 

The  problem  of  investigation  and  analysis  arises  whenever 
a  corporation  approaches  an  investment  banker  with  a  request 
for  assistance  in  the  marketing  of  an  issue  of  securities.  The 
task  of  the  investigation  is,  first,  to  ascertain  whether  the  pro- 
posed issue  is  sound,  and  second,  to  name  a  selling  price  that 
will  be  satisfactory  to  the  corporation  and  at  the  same  time 
enable  the  banker  to  make  a  profit  on  the  transaction.  It 
must  be  clearly  understood  that  the  investment  banking  insti- 
tutions which  we  are  now  considering  have  nothing  to  do  with 
•speculative  securities.  They  aim  to  establish  a  reputation  for 
conservatism;  they  make  their  appeal  primarily  on  the  basis 
of  safety  of  the  principal  and  certainty  of  the  interest  or  divi- 
dends, and  their  greatest  satisfaction  is  in  achieving  a  long 
record  of  no  financial  losses  to  customers. 

In  the  light  of  these  ideals  it  is  obviously  necessary  for  the 
investment  banking  house  to  make  a  most  careful  investigation 
and  analysis  of  the  corporate  securities  which  it  handles.  To 
this  end: 

The  investment  banker  avails  himself  of  all  possible  information 
— that  furnished  by  the  engineer,  the  accountant,  the  banker  and  the 
successful  business  leader — and  reduces  it  all  in  the  crucible  of  his 
experience  and  training.  The  security  which  passes  the  acid  test 
of  this  process  may  be  regarded  as  possessing  the  merits  to  which  the 
reputable  investment  banker  certifies.' 

The  fixing  of  a  price  by  the  investment  banker  is  sometimes 
easy  and  sometimes  difficult.  In  the  case  of  a  corporation  that 
has  outstanding  issues  enjoying  a  broad  and  active  market, 
the  naming  of  a  satisfactory  purchase  price  is  under  ordinary 
drcimastances  not  difficult.    The  existing  market  for  an  issue  of 

'  From  an  article  published  by  A.  H.  Bickmore  &  Company. 


220         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

this  character  is  carefully  studied,  as  well  as  the  general  bond 
market  situation  at  the  time.  A  bid  is  then  made  at  a  figure 
sufficiently  under  current  quotations  for  such  securities  to 
insure  a  reasonable  profit  to  the  investment  banker.  The 
fixing  of  a  price  on  a  new  and  untried  issue,  however,  requires 
the  most  careful  judgment.  The  best  that  can  be  done  is  to 
make  comparisons  with  the  current  prices  of  the  issues  of  a 
similar  character.  Since  the  investment  market  is  often  capri- 
cious, many  losses  are  sustained  by  the  investment  banker. 

The  task  of  investigating  and  analyzing  the  nimierous 
factors  which  govern  the  value  of  investment  securities  varies 
considerably  with  the  different  types  of  issuing  bodies.  In  the 
case  of  governmental  issues,  the  security  rests  primarily  with  the 
adequacy  of  the  taxing  power  possessed  by  the  issuing  govern- 
ment; but  there  is  also  involved  a  consideration  of  the  legality 
of  the  issue.  The  analysis  of  public-utUity  securities  involves 
the  question  of  franchise  rights  and  of  regulation  by  public- 
utility  commissions,  as  well  as  the  potential  earning  power  of 
the  public  utility  in  question.  Similarly  with  railroad  issues, 
there  must  be  considered  the  earning  possibilities  of  the  road, 
together  with  the  regulations  imposed  both  by  the  federal 
government  and  the  various  states  through  whose  territory 
the  railroad  runs.  With  industrial  securities,  the  analysis  is 
largely  concerned  with  the  ascertainment  of  earnings,  although 
in  the  case  of  monopolies  the  problem  of  governmental  regula- 
tion is  also  a  factor.  With  all  classes  of  securities,  the  character 
and  ability  of  the  management  is,  of  course,  a  matter  of  par- 
amount importance. 

The  diagram  on  page  222  is  designed  to  show  the  factors 
that  enter  into  a  determination  of  bond  values.  The  author 
holds  no  brief  for  the  detailed  classification  under  each  heading; 
many  writers  would  doubtless  arrange  the  items  somewhat 
differently.  It  is  believed,  however,  that  the  broad  classifica- 
tion into  legal,  technical,  psychological,  and  economic  factors 
will  assist  the  reader  in  understanding  the  nature  of  the  analysis 
required. 


MARKETING  OF  fflGH-GRADE  SECURITIES  221 

How  an  investment  banker  analyzes  a  proposition.  The 
following  analysis'  of  bond  values  indicates  the  technical  and 
economic  factors  that  must  be  weighed  in  the  balance. 

To  the  task  of  investment  analysis  should  be  brought  an  equip- 
ment that  consists  not  merely  of  a  knowledge  of  accounts;  that  is 
useful  chiefly  to  open  the  gates  of  knowledge.  As  much  informatioc 
as  possible  should  be  gathered  with  respect  to  the  nature  of  the  busi- 
ness, its  methods  and  possibihties  of  operation,  and  the  relation  oi 
the  enterprise  to  the  remainder  of  the  industrial  or  commercial 
conununity.  It  has  been  said  that  the  newspaper  man  should  be  a 
Jack-of -all-trades.  It  might  well  be  said  that  the  dealer  in  securities 
should  be  the  master  of  all  trades.  Through  all  the  investment 
analysis  shoidd  be  applied  the  horse  sense  of  a  sound  business 
experience,  for  financial  miracles  ceased  with  Aladdin  and  his  lamp. 

Investment  analysis  is  concerned  primarily  with  just  three 
things,  as  follows:  (a)  profits;  (6)  the  relation  of  assets  to  liabilities; 
and  (c)  physical  property.  Secondary  factors  are  (a)  the  nature  of 
the  specific  security  offered;  and  (ft)  the  conditions  at  present  existing 
and  likely  to  exist  in  the  investment  market.  Under  these  five 
headings  can  be  taken  into  account  all  the  facts  that  make  or  vmmake 
security  investments.  And  out  of  the  answers  obtained  by  sub- 
jecting questions  to  facts  and  figures  is  constructed  that  projection 
of  opinion — that  prophetic  vision — which  constitutes  the  only  real 
investment  judgment. 

I  confess  to  an  uncontrollable  prejudice  for  a  scrutiny  of  the 
income  accoimt  as  the  first  method  of  approach  to  the  problem  of 
bond  values.  When  an  enterprise  makes  real  money  for  its  share- 
holders, it  also  makes  values  in  use  for  the  physical  property  it  owns. 
....  Physical  values  out  of  use,  even  temporarily,  shrink  to 
oistressingly  small  proportions,  as  the  records  of  the  bankruptcy 
courts  disclose. 

Preliminary  investigation  should  subordinate  the  other  elements 
of  safety  to  the  question  of  earnings.  Current  earnings  and  expenses 
should  be  compared  with  similar  items  at  least  for  the  preceding 
year,  but  preferably  with  those  of  a  number  of  years  preceding. 
Gross  earnings  or  gross  sales  of  merchandise  should  be  expected  to 

*  From  an  article  in  Chicago  Banker,  January  i8,  1913,  by  H.  S.  Mott, 
manager  of  the  bond  department,  Bankers  Trust  Company,  New  York. 


222 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


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MARKETING  OF  HIGH-GRADE  SECURITIES  223 

show  more  or  less  steady  increases,  for  the  business,  like  the  indi- 
vidual, that  merely  stands  still  goes  backward. 

If  one  company  manufactures  harvesting  machines,  another  a 
standard,  moderate-priced  automobile,  and  another  conducts  a  large 
mail-order  business  in  the  rural  districts,  will  the  demand  for  their 
goods  be  affected  by  large  or  small  crops — the  prosperity  or  the  adver- 
sity of  the  farmers  ?  If  a  network  of  trolleys  is  built  in  the  territory 
of  a  railroad,  will  the  road's  passenger  traffic  be  curtailed  ?  If  natural 
gas  is  discovered  near  a  large  city  and  shortly  will  be  delivered  to 
consumers  at  thirty  cents  a  thousand  feet,  how  will  the  company 
manufacturing  gas  for  ninety  cents  a  thousand  feet  to  the  consumer 
be  affected  ?  To  what  extent  is  the  market  for  a  company's  product 
dependent  upon  tariff  duties?  Do  the  records  of  other  similar 
cases  guide  opinion?  Or  is  experience  of  little  service?  In  any 
event  before  we  make  an  investment,  wisdom  dictates  that  we 
form  some  solidly  based  opinion  on  these  or  other  matters  that  may 
be  pertinent.    It  is  the  future  status  of  our  securities  that  interests  us. 

But  suppose,  as  is  frequently  the  case,  we  find  that  the  demand 
for  a  commodity  is  fairly  stable  or,  better  still,  shows  a  well-marked 
tendency  from  year  to  year  to  expand,  with  a  likelihood  that 
the  tendency  will  continue.  It  is  not,  after  all,  gross  earnings  that 
are  applicable  to  dividends  on  stocks,  or,  for  that  matter,  to  interest 
on  bonds;  it  is  net  income.  If  expenses  increase  as  rapidly  as  gross 
earnings,  the  values  of  the  securities  involved  stand  still  or,  in  the 
comparative  appraisals  of  the  market,  decline.  What  do  the  expense 
accounts  show  ?  Does  the  cost  of  conducting  the  business  increase 
more  rapidly  than  do  gross  earnings  or  by  a  larger  percentage? 
If  so,  in  what  items  and  why?  When  these  questions  sKall  be 
adequately  answered,  we  shall  be  in  a  position  reasonably  to  deter- 
mine whether  the  increase  in  expenses,  if  there  be  an  increase, 
is  due  to  avoidable  or  unavoidable  causes,  whether  the  increase  is  a 
fluctuation  or  discloses  a  tendency,  and  whether  part  or  all  of  the 
increase  in  expenses,  such  as  outlay  for  betterment  and  reconstruction, 
is  likely  to  yield  larger  profits  in  the  future. 

The  creation  of  reserve  funds  for  depreciation,  insurance,  etc., 
and  periodical  charges  to  net  earnings  for  their  continuation  and 
expansion  according  to  the  probable  needs  of  the  business  greatly 
enhance  the  investment  values  of  securities.  Property  in  use  derives 
a  large  part  of  its  value  for  a  going  concern  and,  therefore,   for 


224         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

security  holders  by  having  worn-out  parts  constantly  replaced  and 
by  being  protected  against  unusual  hazards.  If,  then,  net  earn- 
ings increase  by  a  percentage  as  large  as,  or  larger  than,  gross 
earnings,  and  if  good  judgment  dictates  that  the  conditions  surround- 
ing the  volume  of  business  done,  the  prices  obtainable,  and  the 
expenses,  are  unlikely  to  change  for  the  worse,  the  securities  of  such  a 
corporation,  other  things  being  equal,  should  be  desirable  investments. 

Assets  and  liabilities.  The  financial  status  of  an  enterprise  at 
the  close  of  business  on  a  particular  day  makes  an  exhibit  with  which 
bankers  as  loaners  of  money  are  familiar.  As  an  exhibit  of  a  com- 
pany's ability  to  repay  loans  in  a  short  time,  it  is  of  more  service 
than  the  income  account.  For  the  purpose  of  investment  analysis 
it  is  subordinate  only  to  the  income  account.  It  is  presumed  to 
be  an  exact  statement  of  all  assets  and  all  liabilities.  Actually,  in 
many  cases,  it  is  nothing  of  the  sort.  The  property  accovmts  among 
the  assets  sometimes  contain  items  of  intangible,  as  well  as  items  of 
tangible,  property.  Good-wiU,  franchises,  patents,  etc.,  when  they 
are  rated  high  as  assets,  produce  water  in  securities  purer  than  that 
to  be  brought  to  New  York  by  the  new  Catskill  aqueduct.  Capital 
stock  theoretically  is  full  paid  and  in  a  balance  sheet  is  treated 
as  money  owed  to  stockholders.  But  actually  it  is  often  not  fully 
paid,  and,  except  as  required  through  dissolution  and  liquidation,  the 
amoimt  it  represents  is  never  legally  owed  to  anybody.  The  surplus 
of  current  assets  over  current  liabilities,  or,  as  surplus  is  called, 
"net  quick  assets,"  constitute  the  working  capital  of  a  concern. 
Its  proportions  in  relation  to  the  need  for  working  capital  are  of  the  i 
utmost  importance.  Many  a  soundly  based  enterprise  has  passed 
iato  cdntrol  of  the  courts  because  its  promoters  failed  to  supply  it 
with  the  sinews  of  war  or  its  management  paid  out  all  profits  in 
dividends. 

In  the  balance  sheet  also  should  appear  the  accumulations  of  the 
various  reserve  funds  which,  to  the  extent  that  they  are  profits 
reserved  against  remote  contingencies,  may  be  considered  as  part  of 
the  surplus  of  profit  and  loss  account.  A  profit  and  loss  account, 
surplus  itself,  may  mean  much  or  little,  according  to  the  nature  of  the 
equities  in  assets  that  it  represents.  A  profit  and  loss  deficit  never 
should  appear  except  in  the  construction  states  of  an  enterprise. 

Among  assets  almost  invariably  the  largest  account  is  "cost 
of  property."  This  account  includes  all  fixed,  or  more  or  less  per- 
manent, assets  needed  in  the  conduct  of  the  business,  such  as  real 
estate,  plants,  machinery,  equipment,  etc.    As  it  is  against  part  or  all 


MARKETING  OF  HIGH-GRADE  SECURITIES  22$ 

of  the  physical  property  included  in  this  account  that  mortgage  bonds 
usually  are  issued,  the  make-up  of  the  account  obviously  is  important. 
In  it  might  be  included  the  original  cost  of  a  branch  railroad  that 
long  had  ceased  to  )deld  profits  or  to  be  kept  in  good  repair,  and  of 
which  the  value  in  use  of  the  physical  property  would  be  hard  to 
discover.  Or  it  might  be  found  that  a  plant  was  adapted  to  profitable 
production  only  under  circumstances  of  manufacture  or  of  competi- 
tion that  have  passed.  Or  worse  than  all,  good-will  may  become 
the  basis  for  the  issuance  of  "mortgage"  securities  through  the 
purchase  of  another  going  concern.  The  methods  of  arriving  at 
"cost  of  property"  through  betterments,  additions,  depreciation 
and  reserve  deserve  careful  consideration.  These  all  have  to  do 
with  the  futurd  status  of  the  mortgaged  fixed  property.  We  should 
make  some  reasonable  determination  that  its  value  in  use  in  the 
future  shall  be  as  much  as,  if  not  actually  more  than,  at  present. 

An  analysis  of  public  utility  values.  The  following  outline- 
analysis  affords  a  general  idea  of  the  sort  of  investigation 
that  must  be  made  in  appraising  the  value  of  public  utility 
securities.^ 

The  data  factors  which  should  enter  into  the  exercise  of  judgment 
involve  balance  sheets,  statements  of  income  and  profit  and  loss, 
and  statistics. 

The  balance  sheet  should  set  forth  with  appropriate  detail  the 
following  items: 

Assets  Liabilities 

1.  The  permanent  iavestment  in    i.  Mortgage  bonded  or  secured 
operated  property  debt 

2.  The  investment  in  non-  2.  Debenture  notes 

operated  property  3.  Customers'   deposits    (in   the 

3.  The  investment  in  securities         case  of  gas  companies) 

or  advances  of  affliated  com-    4.  Current  liabilities  (notes,  ac- 
panies  counts,  dividends,  salaries,  and 

4.  The  liquid  assets  (cash,  receiv-         wages  payable) 

ables,  materials,  etc.)  5.  Reserves  for  depreciation  and 

5.  Deferred  debit  items  losses 

6.  The  cost  of  valuation  carried    6.  Capital,     surplus,     and     im- 
for  franchise  and  good-will  divided  profits  owing  to  share- 
holders 

'  Adapted  from  an  article  by  Homer  A.  Dunn  in  Investment  News, 
March  24,  1917. 


226  THE  FINANCIAL  ORGANIZATION  OF  SOCIEIY 

From  such  a  balance  sheet  four  things  of  importance  to  the 
investor  may  be  readily  determined,  viz. : 

1.  The  excess  of  the  tangible  assets  over  the  liabihties. 

2.  The  financial  progress  of  the  company  as  disclosed  by  the  increase 
or  decrease  in  such  excess  and  its  composition. 

3.  The  cost  or  valuation  of  franchises  or  good-will. 

4.  The  total  capital  (not  capitalization)  invested  and  employed  in 
the  business,  which,  as  courts  have  ruled,  is  the  difference  between 
the  total  assets  and  the  total  liabilities,  or  the  sum  of  the  reserves 
and  shareholders'  accounts. 

By  such  determinations  there  would  be  afforded  bases  for  estab- 
lishing the  ratio  of  net  income  to  the  capital  tangibly  invested  and 
employed  in  the  business. 

In  contemplating  investment  in  mortgage,  bonded,  or  secured 
debt  or  in  debenture  notes  or  similar  obligations,  the  interest  of  the 
investor  should  center  upon  comparison  of  the  ratio  of  net  income - 
producing  power  to  the  capital  tangibly  invested  and  employed  in  the 
business.  If  investment  in  the  common  capital  stock  should  be 
under  consideration,  the  ratio  of  the  net  income-producing  power  to 
the  total  capital  invested  and  employed  in  the  business  would  be  the 
effective  comparison. 

In  analyzing  the  income  account,  a  classification  of  operating 
revenues  and  operating  expenses  is  necessary.  But  the  classification 
will  vary  with  the  nature  of  the  public  utility  in  question.  The 
items  could  not  be  the  same  for  an  electric  utility,  a  gas  utility,  and 
a  traction  utility.  A  summary  of  the  operating  revenues  of  an  electric 
utility,  for  example,  might  well  cover  (i)  commercial  lighting  and 
power;  (2)  municipal  lighting  and  power;  (3)  sales  of  current  to 
other  utilities;  (4)  profit  on  wiring  and  installation;  (5)  profit  on 
sales  of  merchandise;   (6)  miscellaneous  operating  revenue. 

Again  using  an  electric  utility  as  an  example,  such  a  summary  of 
the  operating  expenses  might  well  cover  (i)  generation  and  storage 
operation;  (2)  transmission  and  distribution  operation;  (3)  utiliza- 
tion expenses;  (4)  commercial  expenses;  (5)  repairs  of  generation 
and  storage  structures;  (6)  repairs  of  generation  and  storage  equip- 
ment; (7)  repairs  of  transmission  and  distribution  systems;  (8)  depre- 
dation of  generation  and  storage  structures;  (9)  depreciation  of 
generation  and  storage  equipment;  (10)  depreciation  of  transmission 
and  distribution  structures;  (11)  depreciation  of  transmission  and 
distribution  equipment;  (12)  general  expenses;  (13)  administration 
expenses. 


MARKETING  OF  fflGH-GRADE  SECURITIES  227 

The  income  derived  from  sources  other  than  operating  activities 
should  be  disclosed  in  such  items  as  (i)  rentals  from  non-operated 
property;  (2)  interest  earned  on  investments  in  mortgage,  bonded, 
and  secured  debt;  (3)  dividends  declared  on  investments  in  capital 
stocks  of  other  companies;  (4)  interest  earned  on  bank  balances  and 
notes  and  accounts  receivable;  (5)  cash  discount  earned  on  purchases; 
(6)  unclaimed  salaries  and  wages  written  ofif. 

Income  charges.  The  income  charges  should  consist  of  such 
items  as  (i)  interest  on  mortgage,  bonded,  and  secured  debt;  (2)  inter- 
est on  debenture  notes  or  similar  obligations;  (3)  interest  on  cvurent 
liabilities;  (4)  rent  of  property  used  in  operations;  (5)  excise  and 
franchise  taxes;  (6)  income  tax  (property  taxes  being  included  in 
general  expenses). 

Throughout  this  summary  of  income  there  should  be  a  series  of 
totals  and  remainders,  a  recapitulation  of  which,  followed  by  the 
items  which  ordinarily  should  enter  into  the  profit  and  loss  account, 
is  as  follows: 

Total  operating  revenue 
Total  operating  expenses 
Net  operating  revenue 
Total  other  income  credits 
Gross  income 
Total  income  charges 
Net  income 

Profit  and  loss  surplus  at  beginning  of  the  year 

Profit  realized  on  investment  securities  sold 

Profit  realized  on  non-operated  property  sold 

Profit  and  loss  gross  surplus 

Profit  and  loss  charges: 
Loss  sustained  on  investment  securities  sold 
Loss  sustained  on  non-operated  property  sold 
Dividends  declared  during  the  year  (stating  the  amount  and 

rate  for  each  class  of  capital  stock) 
Total  charges 

Profit  and  loss  surplus  at  the  end  of  the  year 

The  illustrations  above  serve  only  to  reveal  the  nature  of 
the  investment  banker's  task  of  investigation  and  analysis; 
they  do  not  supply  the  reader  with  the  golden  key  to  the 
treasure-houses  of  industry.    It  is  enough  for  the  present  to 


228        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

note  that  the  success  of  the  investment  banker  will  vary  with 
the  degree  of  his  mastery  of  the  legal,  technical,  psychological, 
and  general  economic  factors  which  enter  into  the  determina- 
tion of  investment  values. 

V.    THE  UNDERWRITING  FUNCTION 

The  ability  of  a  corporation  to  construct  new  plant  and 
equipment  or  to  extend  the  scope  of  its  operations  in  any  direc- 
tion is  dependent  upon  an  available  supply  of  funds.  Since 
an  issue  of  bonds  or  stock  is  subject  to  the  conditions  of  a 
capricious  market,  the  securities  can  sometimes  be  quickly 
sold  to  the  investing  public  at  a  favorable  price,  while  at  other 
times  it  may  require  months  or  even  years  for  them  to  be 
absorbed  at  almost  any  price.  The  function  of  underwriting 
has  arisen  as  a  means  of  protecting  the  borrowing  corporation 
from  the  vagaries  of  the  investment  market — of  insuring  that  it 
shall  obtain  possession  of  the  fimds  required  at  the  precise  time 
that  they  are  needed. 

It  is  difficult  to  give  a  clear  presentation  of  the  function 
of  underwriting  for  the  reason  that  th6  term  is  often  loosely 
used,  having  a  different  meaning  for  different  people.  It  will 
make  for  clearness  of  understanding,  however,  if  we  keep  always 
in  mind  the  fact  that  whoever  participates  in  underwriting 
agrees,  if  a  slang  expression  may  be  pardoned,  to  "hold  the  bag" 
in  case  the  securities  are  not  sold  to  ultimate  investors.  Some- 
times a  single  institution  may  underwrite  an  entire  issue;  but  in 
more  cases  a  considerable  number  of  houses  unite  for  the  purpose. 

In  the  diagram  on  page  218,  underwriting  is  placed  in  an 
intermediate  position  between  investigation  and  analysis,  and 
distribution.  There  is  good  reason  for  this,  because  in  point 
of  time  the  underwriting  arrangement  follows  the  investigation 
and  analysis  and  precedes  the  distribution  of  securities.  In  the 
case  of  a  small  issue  handled  by  a  single  house,  which  makes 
the  investigation,  assumes  the  underwriting  and  distributes 
the  entire  issue,  there  is,  of  course,  little  point  to  such  a  differ- 
entiation;  but  the  reader  will  find  it  of  distinct  assistance  in 


MARKETING  OF  HIGH-GRADE  SECURITIES  229 

reaching  an  understanding  of  the  process  of  marketing  securities 
in  cases  where  an  underwriting  syndicate  is  formed. 

A  joint-account  arrangement,  or  an  underwriting  syndicate, 
is  formed  whenever  a  house  has  in  charge  an  issue  that  is  larger 
than  it  can  handle  conveniently  with  its  own  resources.  There 
are  a  number  of  investment  banks  in  the  larger  cities  of  the 
country  with  sufficient  resources  to  handle  an  issue  of  securities 
of  $2,000,000  or  $3,000,000.  With  issues  in  excess  of  this 
amount,  however,  there  are  only  a  few  concerns  equipped  to 
handle  them  without  assistance.  In  New  York  there  are  per- 
haps seven  or  eight,  in  Boston  three  or  four,  in  Chicago  and 
Philadelphia  two  or  three  each,  that  can  handle  issues  in  excess 
of  $5,000,000. 

The  nature  of  the  entire  process  of  underwriting  and 
marketing  securities  may  best  be  revealed  by  some  concrete 
illustrations  involving  the  joint-account  arrangement  and  the 
underwriting  syndicate. 

Under  a  joint-account  arrangement  several  investment  hankers 
^^participate"  in  the  underwriting.  Suppose,  for  instance,  that 
company  A  has  in  charge  an  issue  of  securities  which  it  cannot 
handle  satisfactorily  alone.  It  seeks  the  assistance  of  com- 
panies B,  C,  and  D.  Let  us  assume  that  the  amount  of  the  issue 
is  ten  million  dollars  and  that  the  A  company  takes  four  millions 
and  the  B,  C,  and  D  companies  two  millions  each.  Under  this 
arrangement  each  banking  house  agrees  to  advance  to  the  cor- 
poration on  a  stipulated  date  a  sum  of  money  proportionate  to 
the  extent  of  its  participation.  To  be  concrete,  let  us  suppose 
that  the  A  company  had  decided  that  the  bonds  could  be 
marketed  at  $98  per  share  and  that  in  view  of  the  expenses 
incident  to  the  marketing  process,  the  corporation  should 
receive  $95  per  share.  The  corporation  would  therefore  receive 
$9,500,000,  four-tenths  of  which  would  be  underwritten  by  A 
and  two-tenths  by  B,  C,  and  D  respectively.  If  the  bonds 
were  sold  at  $98,  the  gross  profit  to  the  four  concerns  for  bring- 
ing out  the  issue  and  underwriting  and  distributing  it  would 
be  $30,000,  from  which,  01  course,  would  have  to  be  deducted 
tJie  expenses  incident  to  the  business. 


230         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Let  us  suppose  that  the  issue  had  been  underwritten  on 
January  i  and  that  the  date  fixed  for  payment  of  the  funds  to 
the  corporation  was  April  i.  If  investors  look  upon  the  issue 
with  favor  at  the  price  of  $98,  it  may  be  that  it  can  all  be  sold 
during  the  interval;  but  if  the  investors  are  not  favorably  dis- 
posed it  may  be  that  only  a  small  portion — or  indeed  none  of 
the  issue — can  be  sold  before  April  i.  In  this  event,  the  par- 
ticipating investment  bankers  must  advance  the  balance  to 
the  corporation  out  of  their  own  resources  or  with  funds  bor- 
rowed from  commercial  banks.  Since  their  own  resources  are 
usually  relatively  small  in  proportion  to  the  volume  of  securities 
which  they  are  handling,  it  is  generally  necessary  to  borrow 
heavily,  on  the  basis  of  promissory  notes,  backed  by  the  securi- 
ties that  are  being  underwritten  as  collateral. 

If  the  bond  market  continues  to  be  apathetic  with  reference 
to  this  particular  issue,  the  participants  will  either  have  to 
"carry  the  securities"  on  borrowed  funds  for  a  considerable 
period,  sometimes  several  years,  or  offer  them  at  a  lower  price 
to  the  public.  The  former  alternative  involves  tying  up  funds 
for  an  indefinite  period,  with  a  loss  of  interest  during  the  interval; 
the  latter  involves  accepting  a  loss  through  selling  at  a  price 
that  will  not  cover  the  expenses  that  have  been  incurred. 

Under  this  joint-account  arrangement  the  houses  concerned 
act  both  as  underwriters  and  distributors.  They  divide  the 
profits,  or  losses,  in  direct  proportion  to  the  participation, 
regardless  of  the  number  of  shares  each  house  may  be  able  to 
sell.  The  joint-account  is  a  species  of  partnership.  It  usually 
calls  for  an  undivided,  or  unlimited,  liability  of  the  participants, 
though  sometimes  the  agreement  provides  for  a  division  of  the 
liability.  The  securities  are  also  handled  as  a  "lump,"  under 
the  management  of  some  member  of  the  group  of  associated 
houses;  even  the  borrowing  from  the  banks  is  a  joint  affair. 

The  underwriting  ''syndicate"  assumes  the  risks  of  marketing. 
In  the  case  of  large  issues,  and  oftentimes  with  small  issues 
handled  by  a  banking  house  or  houses  of  limited  resources,  a 
syndicate  is  formed  for  the  purpose  both  of  distributing  more 
widely  the  risks  involved  and  of  facilitating  the  sale  of  the 


MARKETING  OF  HIGH-GRADE  SECURITIES  231 

securities.  Such  a  syndicate  may  be  formed  by  an  individual 
house,  or  by  a  group  of  houses  handling  an  issue  of  securities 
on  joint-account,  as  described  above. 

To  make  the  illustration  as  concrete  as  possible,  let  us 
assume  that  Lee  Higginson  &  Co.  have  investigated  a  proposi- 
tion for  an  issue  of  $50,000,000  of  7  per  cent  bonds.  Since  the 
issue  is  larger  than  could  be  handled  successfully  by  a  single 
house,  or  even  by  a  group  of  houses  operating  on  joint-account, 
Lee  Higginson  &  Co.  proceed  to  organize  a  syndicate  to  under- 
write the  issue.  Lee  Higginson  &  Co.  alone  deal  with  the 
borrowing  corporation,  acting  as  an  intermediary  between  the 
houses  which  participate  in  the  underwriting  and  the  corpora- 
tion whose  securities  are  being  issued.  The  issue  is  their 
proposition  and,  as  we  shall  see,  they  get  a  special  return  as 
a  reward  for  bringing  out  the  issue  and  for  organizing  and 
managing  the  syndicate. 

In  the  case  under  consideration,  suppose  that  Lee  Higginson 
&  Co.  have  agreed  to  pay  to  the  corporation  $92  per  bond,  and 
that  they  have  decided  to  offer  the  issue  to  the  investing  public 
at  96.  Assume  also  that  a  commission  of  i  per  cent  must  be 
paid  to  those  who  assist  in  the  selling  of  the  securities.'  This 
leaves  a  possible  three-point  difference  for  profits  to  the  mana- 
gers of  the  issue.  If  no  underwriting  syndicate  were  formed,  this 
would  all  go  to  Lee  Higginson  &  Co. ;  but  since  this  house  has 
not  suflScient  resources  to  assume  conveniently  the  risks  involved 
in  so  large  a  venture,  they  forego  the  chance  of  securing  all 
the  profits — and  of  standing  all  the  losses — and  distribute  the 
opportimity  and  the  risk  among  a  number  of  houses. 

Let  us  now  assume  that  the  underwriters  in  the  case  above 
agree  to  buy  at  93  any  bonds  that  are  not  taken  by  the  public 
at  96,  before  the  date  set  for  advancing  the  funds  to  the  cor- 
poration. Lee  Higginson  &  Co.  are  thus  assvured  of  a  profit 
of  $1  per  $100  bond,  less  expenses  for  their  services  in  con- 
nection with  the  original  analysis  and  investigation  and  the 

'  If  the  investment  market  improves,  the  securities,  of  course,  might 
be  sold  at  more  than  $96;  but  if  the  market  is  dull  they  may  have  to  be 
sold  for  less. 


232         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

organization  and  management  of  the  underwriting  syndicate. 
By  virtue  of  their  agreement  with  the  underwriters  they  have 
contracted  themselves  out  of  any  risk  of  loss,  except  as  they  also 
may  participate  in  the  underwriting  process,  as  noted  below. 

It  is  often  good  business  policy  for  a  large  house  to  organize 
an  underwriting  syndicate,  even  though  it  could  assume  the 
entire  risks  alone.  By  calling  in  a  number  of  houses  to  partici- 
pate in  the  underwriting  it  conserves  some  of  its  own  resources 
and  thereby  is  enabled  to  take  on  additional  issues  as  oppor- 
tunity offers^ — additional  issues  on  which  it  will  receive  a  return 
for  its  work  as  original  investigator  and  as  organizer  and 
manager  of  a  new  syndicate. 

If  the  sale  is  a  success,  the  underwriters  who  have  agreed 
to  buy  at  93  the  bonds  which  are  sold  at  96  receive  2  per  cent 
for  the  risk  they  have  assumed — the  distributors  getting  the 
other  I  per  cent  as  noted  above.  If  the  sale  is  not  a  success, 
the  underwriters  must  buy  in  the  bonds  at  93,  and  then  either 
tie  up  capital  indefinitely  by  holding  the  securities  for  a  mort 
favorable  market,  or  accept  a  heavy  loss  by  selling  at  a  figmrt 
below  their  purchase  price.  If  they  elect  to  "carry"  the 
securities  it  will  be  necessary  for  them  to  borrow  most  of  th*» 
requisite  funds  from  the  commercial  banks. 

Many  institutions  participate  in  the  underwriting.  In  the 
case  of  an  underwriting  syndicate  of  the  sort  just  described, 
the  house  of  first  purchase  may  also  participate  in  the  under- 
writing, thus  acting  in  a  double  capacity.  Similarly,  the  partici- 
pating underwriting  houses  may  perform  a  double  function, 
that  of  taking  subscriptions  for  the  sale  of  bonds  and  assuming 
the  risks  of  underwriting.  In  the  example  above,  an  invest- 
ment banker  would  receive  $1  per  bond  as  a  distributing  agency, 
and  $2  as  an  underwriter.  It  is  important  to  bear  in  mind, 
however,  that  the  actual  amounts  received  for  any  of  the 
functions  connected  with  the  marketing  of  securities  vary  with 
different  issues  and  at  different  periods  of  time. 

Large  investors  in  securities  often  participate  in  under- 
writings,  in  order  to  reap  the  advantage  of  a  lower  price  in 
their  purchase  of  securities.     Insurance  companies  have  also 


MARKETING  OF  HIGH-GRADE  SECURITIES  233 

at  times  participated  in  such  undertakings,  but  owing  to  alleged 
abuses  the  state  of  New  York  has  now  made  it  illegal  for  these 
institutions  to  engage  in  syndicate  activities. 

One  of  the  things  to  be  guarded  against  by  the  underwriting 
S5aidicate  is  the  passage  of  an  issue  of  securities  into  the  hands 
of  speculators  before  the  expiration  of  the  underwriting  agree- 
ment. If  purchased  by  speculators  who  have  misjudged  the 
potential  demand,  securities  will  often  be  thrown  on  the  market 
at  a  loss.  Such  precipitate  selling  may  serx'^e  greatly  to  depress 
the  price,  with  resulting  losses  to  the  underwriters.  In  an 
endeavor  to  prevent  the  disposition  of  securities  to  speculators 
it  is  stipulated  that  when  individuals  participate  in  under- 
writing it  must  be  for  investment  purposes  only.  A  new  issue 
of  securities  may,  however,  pass  indirectly  into  the  hands  of 
speculators  by  way  of  the  regular  dealers.  Every  effort  is 
made  to  prevent  this  and  to  restrict  the  sale  to  investment 
charmels.  In  case  an  issue  does  not  "go  well,"  however,  and 
the  underwriters  are  forced  to  sustain  their  losses,  the  securities 
then  pass  in  large  blocks  into  the  stock  market,  where  for  years 
they  are  the  object  of  speculative  activity.  The  economic 
consequences  of  this  aspect  of  the  problem  will  be  considered 
in  the  next  chapter. 

Syndicates  are  always  temporary  organizations,  being 
dissolved  as  soon  as  a  particular  transaction  is  completed. 
They  are  being  formed  continuously,  however,  and  a  given 
house  may  at  one  time  be  a  member  of  several  syndicates.  It 
is  usually  good  business  policy  to  form  an  underwriting  syn- 
dicate, apart  from  the  reason  noted  on  page  232,  for  syndicate 
operations  enable  a  wider  distribution  of  risks.  Invitations 
to  participate  in  syndicate  operations  are  usually  reciprocal; 
and  the  risks  are  obviously  more  widely  distributed  if  a  house 
has  underwritten  a  million  of  securities  issued  by  five  different 
companies  than  when  it  has  underwritten  a  million  of  a  single 
issue.^ 

'  For  additional  data  on  sjTidicate  questions  see  chap.  xxx. 


234         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

VI.    THE  DISTRIBUTION  FUNCTION 

The  volume  of  corporate  securities  has  attained  such 
enormous  proportions  in  recent  years  that  the  distribution 
function  has  required  the  development  of  elaborate  selling 
organizations.  It  has  been  estimated  that  the  par  value  of 
the  American  bonds  sold  each  year  averages  more  than  $2,000,- 
000,000;  while  the  high-grade  stocks  distributed  by  bond  houses 
are  now  doubtless  of  equal  amount.  In  1914  there  were  about 
1,000  large  investment  banking  institutions  in  the  United  States 
and  a  large  number  of  small  retail  dealers.  This  number 
has  probably  been  substantially  increased  as  a  result  of 
the  impetus  that  was  given  to  the  investment  business  by  the 
financial  exigencies  of  war  and  reconstruction.  Besides  the 
large  houses,  which  exercise  at  once  the  functions  of  investiga- 
tion and  analysis,  underwriting,  and  distribution,  there  are 
many  small  dealers  and  brokers  who  assist  in  the  retailing 
of  securities. 

The  larger  houses  maintain  offices  in  the  leading  financial 
centers,  such  as  New  York,  Boston,  and  Chicago,  and  also  in 
London.  The  American  offices  are  all  connected  by  private 
wires  and  it  is  not  unusual  for  a  single  concern  to  dispose  of 
$5,000,000  worth  of  bonds  in  a  day.  In  order  to  accomplish 
such  a  feat  it  is  necessary  for  the  banking  house  to  be  in  close 
communication  with  institu1;jons,  brokers,  and  groups  of  indi- 
viduals who  can  act  quickly  and  buy  in  large  quantities.' 
A  considerable  percentage  of  such  sales  would  be  to  the  smaller 
dealers  and  brokers,  and  much  of  the  remainder  to  savings 
banks,  and  insurance  and  trust  companies. 

As  already  indicated,  distribution  relates  to  the  selling  end 
of  the  bond  business,  to  the  placing  of  securities  in  the  hands 
of  ultimate  investors.  To  guard  against  confusion  of  thought 
it  may  again  be  stated  that  distribution  is  not  a  function  -which 
is  specialized  in  exclusively  by  certain  houses.  All  of  the  invest- 
ment banks  perform  this  as  well  as  the  other  functions.  For 
instance,  when  a  single  house  brings  out  an  issue  of  securities 

'  See  list  of  these  on  pp.  237-38. 


MARKETING  OF  fflGH-GRADE  SECURITIES  23S 

and  underwrites  it  without  assistance,  it  also  markets  the  issue. 
Similarly,  when  a  groiip  of  houses,  operating  on  joint-account, 
together  underwrite  an  issue,  they  also  unite  in  the  selling 
process.  And  when  a  syndicate  has  been  organized,  the  various 
houses  participate  both  in  the  underwriting  and  in  the  distri- 
bution of  the  issue;  indeed,  the  participating  houses  are  often 
spoken  of  as  a  ''selling  syndicate."  In  general  it  may  be  said, 
however,  that  the  tendency  is  for  only  one  house,  or  a  small 
group  of  houses,  to  bring  out  an  issue  and  organize  the  syndi- 
cate; for  a  considerable  number  of  houses  to  participate  in  the 
underwriting;  and  for  a  much  larger  number  to  take  part  in 
the  selling  campaign. 

With  any  given  issue,  however,  there  may  be  a  considerable 
number  of  houses  that  have  not  participated  in  the  under- 
writing who  do  undertake  to  sell  some  of  the  securities.  Among 
those  assisting  in  the  distribution,  but  usually  not  participat- 
ing in  the  underwriting,  are  also  local  banks  throughout  tht 
country,  with  bond  departments,  formally  or  informally  organ- 
ized, small  securities'  dealers,  and  brokers  working  for  a  small 
commission. 

It  should  be  noted,  also,  that  a  member  of  the  syndicate  is 
not  necessarily  obliged  to  sell  the  same  amount  of  securities 
that  it  has  underwritten.  For  instance,  a  house  may  agree  to 
underwrite  $100,000  worth;  but  it  may  undertake  to  sell  only 
$50,000.  If  the  entire  issue  is  successfully  marketed,  the  house 
in  question  receives  its  underwriting  profit  on  $100,000  and  its 
distributing  commission  on  $50,000.  If  the  issue  is  not  alf 
sold,  it  must  buy  in  its  proportion  of  the  unsold  amount  and 
assimie  the  risks  of  marketing  them  at  a  loss.  It  would  still 
receive  its  selling  commission,  however,  on  whatever  amount 
it  had  individually  succeeded  in  marketing.  It  will  be  observed 
that  it  is  quite  possible  that  any  particular  house  may  be  able 
to  sell  all  the  securities  for  which  it  has  subscribed,  despite  the 
fact  that  the  entire  issue  is  not  sold. 

All  who  participate  in  the  distribution  of  securities,  whether 
members  of  the  syndicate  or  not,  are  entitled  to  a  selling  com- 
mission.   The  amount  of  this  commission  varies  somewhat. 


236         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

depending  upon  the  nature  of  the  issue  and  the  condition  of 
the  investment  market.  It  varies  also  with  the  size  of  the 
subscription.  The  commission  to  brokers  is  usually  very 
small,  typically  one-fourth  of  i  per  cent.  The  commissions 
given  to  local  banks  and  dealers  run  typically  from  ^  to  i 
per  cent. 

The  distributors  assume  some  of  the  risks.  In  a  sense  the 
outside  distributors,  that  is,  those  not  members  of  the  under- 
writing syndicate,  also  perform  an  underwriting  function;  for 
they  are  not  permitted  to  return  any  securities  for  which  they 
have  subscribed.  This  rule  applies  to  brokers,  as  well  as  to 
banks  and  dealers.  Since  the  outside  distributors  buy  at  a 
fixed  price,  say  $1  less  than  the  price  to  the  public,  they  are 
taking  a  chance  of  not  being  able  to  market  the  securities  at  a 
profit.  If  the  issue  does  not  go  well,  they  will  have  either  to 
sell  at  a  price  below  what  they  have  paid  for  the  securities,  or 
to  hold  them  for  a  rise.  It  will  be  noted,  however,  that  while 
these  small  houses  and  brokers  thus  assimie  some  of  the  risks 
involved,  their  risks  as  distributors  are  only  in  proportion  to 
their  purchases;  they  do  not  guarantee  that  the  entire  issue 
will  be  bought,  as  does  the  original  underwriting  S5mdicate. 
Another  way  of  stating  it  is  that  the  original  underwriters 
assmne  the  risks  first,  and  then  distribute  them,  in  whole  or  in 
part,  as  the  case  may  be,  to  the  distributing  houses. 

Not  being  members  of  the  syndicate,  these  retail  dealers, 
banks,  and  brokers  are  not  debarred  from  selHng  below  the 
syndicate  price  before  the  termination  of  the  syndicate  under- 
writing agreement,  as  is  the  case  with  the  participants  in  the 
syndicate.  The  dealers  and  local  banks  seldom  cut  prices 
before  the  expiration  of  the  underwriting  agreement,  through 
fear  of  incurring  the  ill  will  of  the  syndicate,  and  thereby 
lessening  their  chances  of  assisting  in  the  distribution  of  future 
issues.  The  brokers,  however,  usually  feel  little  of  this  com- 
pulsion; and  to  guard  against  their  underselling  and  thereby 
increasing  the  risks  of  the  underwriting  syndicate,  brokers' 
commissions  are  usually  very  small — one-fourth  of  i  per  cent. 
In  other  words  the  price  quoted  them  is  one-fourth  of  a  pei 


MARKETING  OF  fflGH-GRADE  SECURITIES  237 

cent  below  the  regular  price.  They  cannot,  therefore,  cut 
more  than  one-eighth  of  a  per  cent  without  wiping  out  the 
entire  profit. 

There  is  usually  a  public  announcement  of  an  offering  of 
securities.  When  an  underwriting  syndicate  has  been  perfected 
and  an  issue  of  securities  is  ready  for  distribution,  it  is  neces- 
sary to  attract  the  attention  of  potential  investors.  This  is 
customarily  done  by  means  of  a  public  announcement,  which 
formally  calls  attention  to  the  amount  of  the  issue,  the  terms, 
and  the  date  by  which  subscriptions  must  be  in.  In  many  cases 
a  great  deal  of  general  advertising  has  been  quietly  done  before 
the  public  announcement  is  made;  indeed,  the  securities  may 
all  have  been  subscribed  for  in  advance,  in  which  case  the  public 
announcement  might  be  regarded  as  superfluous,  except  that 
it  affords  an  opportunity  to  call  attention  to  the  significant 
fact  that  the  bonds  have  already  been  disposed  of,  thereby 
adding  to  the  prestige  of  the  house  or  syndicate.  The  public 
announcement  is  aimed  at  investors  en  masse,  and  it  is  effective 
in  proportion  to  the  attractiveness  of  the  particular  issue  and 
the  condition  of  the  investment  market. 

The  subscribers  include,  as  already  noted,  the  houses  which 
have  participated  in  the  syndicate,  other  bond  houses,  dealers 
and  brokers,  and  a  number  of  closely  associated  financial 
institutions.  One  writer  has  listed  the  following  among  these 
associated  institutions: 

1.  An  insurance  company  and  its  directors,  who,  if  rich  men,  will 
probably  buy  for  their  own  account  some  portion  of  a  bond  issue 
that  their  company  has  taken. 

2.  A  firm  of  bankers  or  a  bank  in  a  smaller  city  that  supplies  a 
local  iQvestment  demand. 

3.  A  European  group  or  syndicate  that  acts  as  a  secondary  dis- 
tributor or  buys  securities  against  which  it  issues  its  own  debentures, 
as  in  the  case  of  the  Scotch  trust  companies  and  the  investment 
associations  of  HoUand. 

4.  Individual  trustees  or  lawyers  charged  with  the  investment 
of  large  estates,  who  are  generally  willing  to  anticipate  their  reqviire- 
ments  if  anything  especially  choice  is  for  sale. 


238         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

5.  Trust  companies  and  their  correlated  banks,  whose  purchases 
may  be  either  for  the  trust  funds  of  the  former  or  as  an  investment 
for  the  deposits  of  both. 

6.  Savings  banks,  which,  taken  as  a  class,  are  the  largest  insti- 
tutional buyers  of  the  classes  of  bonds  to  which  they  are  restricted 
by  the  laws  of  the  various  states. 

The  list  of  the  various  subsidiary  groups  among  wMch  the  dis- 
tributor of  bonds  finds  his  best  market  might  be  extended  almost 
indefinitely,  but  those  described  will  give  a  reasonably  clear  idea  of 
what  may  be  called  the  headwaters  of  the  investment  stream  that 
must  be  kept  continually  flowing  into  the  bond  market.' 

Since  each  subscription  is  made  in  ignorance  of  the  amount 
that  is  being  subscribed  for  by  other  houses,  an  issue  may  be 
considerably  over-  or  considerably  undersubscribed.  In  the 
case  of  an  oversubscription,  allotments  of  bonds  for  distribution 
are  made  in  such  proportion  as  the  total  number  of  bonds  to  be 
issued  bears  to  the  total  amount  subscribed  for.  For  instance, 
if  an  issue  has  been  oversubscribed  by  25  per  cent,  the  number  of 
bonds  available  would  be  to  the  number  of  bonds  subscribed 
for  as  100  to  125,  or  4  to  5;  hence  if  a  house  has  subscribed  for 
$100,000  of  bonds  it  would  be  allotted  $80,000  and  the  dis- 
tributor's commission  would  be  paid  on  only  $80,000.  If,  on  the 
other  hand,  the  issue  is  undersubscribed,  the  subscribing  house 
receives  its  commission  on  the  amoimt  actually  subscribed 
for.  It  will  be  recalled,  however,  that  the  receipt  of  the  com- 
mission is  contingent  upon  the  ability  of  the  house  to  sell  the 
amount  for  which  it  has  subscribed  at  a  price  above  its  purchase 
price. 

The  second  part  of  the  selling  program  is  the  more  difl&cult — 
that  of  convincing  individual  investors  by  direct  and  personal 
appeal  of  the  soundness  and  attractiveness  of  the  issue  in  ques- 
tion. If  the  bond  market  is  apathetic  or  crowded  with  issues — 
if,  as  the  phrase  goes,  there  are  many  undigested  securities 
floating  around — the  selling  of  the  entire  issue  may  prove  a 
very  difficult  and  long-drawn-out  affair.  It  involves  the  use 
of  advertising  literature  sent  through  the  mails,  and  to  an 

'  Theodore  H.  Price,  The  Outlook,  CVI  (1Q14),  S08. 


MARKETING  OF  HIGH-GRADE  SECURITIES  239 

ever-increasing  extent  it  requires  expert  salesmanship.  In 
former  days  when  the  issues  of  securities  were  few  and  when 
the  announcement  of  a  new  offering  was  always  an  event  of 
importance,  advertising  literature  made  an  effective  appeal; 
but  under  present  conditions,  with  a  large  number  of  bond 
houses  and  with  thousands  of  different  issues,  the  mails  are  to 
some  extent  losing  their  effectiveness.  Much  of  this  advertis- 
ing literature  is  consigned  to  the  waste-paper  basket  by  the 
busy  man  of  affairs  without  so  much  as  a  glance  at  the  offer. 
Personal  appeal  through  salesmen  is  increasingly  necessary  to 
bring  results. 

The  following  is  a  t5^ical  letter  to  regular  clients  and  poten- 
tial purchasers: 

A  REMARKABLE  OFFERING 

Insuring  the  Investor 
Safety  of  Principal  and  Income  of  Practically  8% 

$500,000 

Hurley  Machine  Company 
(An  lUinois  Corporation) 

7%  Ciunulative  Sinking  Fund  Preferred  Stock 

The  Hurley  Machine  Company,  established  in  Chicago  eleven 
years  ago,  is  the  World's  largest  producer  of  electric  washing  devices, 
the  "Thor  Electric  Washing  Machine,"  standing  alone  in  its  class 
as  the  most  efficient  in  use  and  protected  by  valuable  patent  rights. 
The  vacuum  cleaner,  also  produced  by  this  Company,  has  tremendous 
possibilities,  as  indicated  by  the  sales  the  week  before  Christmas 
of  more  than  3,000  cleaners.  The  products  manufactured  are 
standard  articles  in  universal  and  increasing  demand  for  the  home. 
They  are  so  weU  constructed  that  expense  for  repairs  is  practically 
negligible. 

Through  this  new  capital  the  Company  is  provided  with  facilities 
to  increase  its  output  from  400  to  600  per  cent  over  its  191 7  sales 
and  at  a  lower  imit  of  cost  of  production.  Each  month  of  its  exist- 
ence the  Company  has  shown  an  increase  in  business  over  the  corre- 
sponding month  of  the  previous  year.  The  Hurley  Company 
products  are  essential  labor-saving  devices,  particularly  necessary 
under  existing  conditions.  They  are  a  war-time  as  well  as  a  peace 
necessity. 


240         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

After  maMng  every  provision  for  expenses,  depreciation,  federal 
income,  and  other  taxes,  the  net  profits  for  1917  applicable  to 
the  Preferred  Stock  averaged  every  sixty  days  more  than,  suffi- 
cient TO  PAY  THE  DIVIDEND  FOR  THE  ENTIRE  YEAR. 

After  allowing  for  dividends  on  the  Preferred,  the  Common 
Stock  during  191 7  earned  more  than  $15.50  per  share,  while  the 
dividend  rate  of  6%  per  annum  is  being  paid  quarterly,  January, 
April,  July  and  October  15,  as  for  a  number  of  years  past. 

The  connection  of  Mr.  Edward  N.  Hurley  with  the  enterprise, 
originated  by  himself,  and  an  exceptionally  able  board  of  directors 
should  insure  the  continued  success  of  the  business. 

PRICE 

The  Preferred  Stock  is  offered  at  $100  per  share  and  accrued 
dividend  from  January  i,  191 8,  carrying  with  it  15%  in  Common 
Stock. 

There  is  a  firm  bid  of  $75  per  share  for  the  Common  Stock  and 
we  will  pay  this  price  for  any  of  this  stock  which  you  may  acquire, 
or  we  would  be  willing  to  purchase  or  sell  any  fractional  share  on 
the  same  basis. 

Recommended  without  qualification  by 

John  Burnham  and  Company 
January  26,  1918 

(Company's  descriptive  folder,  including  balance  sheet,  certified  by 
chartered  accountant,  accompanies  the  letter.) 


VII.    SUNDRY  SERVICES  OF  INVESTMENT  BANKERS 

One  of  the  chief  problems  of  any  bond  house  is  that  of  build- 
ing up  a  clientele — a  task  which  usually  requires  several  years 
of  activity  in  the  cultivation  of  cordial  relations  based  on  service. 
Investment  bankers  aim  to  make  satisfied  customers  by  selling 
only  such  securities  as  are  safe  and  at  the  same  time  yield  a 
satisfactory  interest  return.  They  also  render  a  number  of 
important  incidental  services  to  their  clients. 

The  investment  banker  often  becomes  an  adviser  to  his 
customers  and  assists  them  in  selecting  the  best  types  of  securi- 
ties for  their  particular  requirements.    He  also  furnishes  a 


MARKETING  OF  HIGH-GRADE  SECURITIES  241 

great  deal  of  general  information  on  all  matters  pertaining  to 
the  investment  business,  and  frequently  offers  a  general  inves- 
tor's service,  as  distinguished  from  the  special  service  rendered 
when  a  particular  security  is  sold.  Bond  houses  furnish  reports 
to  customers  on  any  securities,  municipal  or  corporate,  which 
are  of  public  record;  and  they  answer  questions  about  securi- 
ties based  upon  information  which  the  investment  house  has 
accumulated  and  which  it  believes  to  be  reliable.  Tabloid 
investment  lessons  are  often  printed  in  the  columns  of  news- 
papers and  periodicals,  in  pamphlets  and  monographs;  and 
some  houses  even  put  out  a  daily  news  sheet  containing  items 
of  interest  to  investors  and  suggestive  discussions  of  investment 
problems. 

While  bond  houses  cannot  guarantee  the  payment  of  prin- 
cipal and  interest,  they  sometimes  do  assume  customers'  losses. 
"In  some  instances  losses  amounting  to  hundreds  of  thousands 
of  dollars  have  been  made  good;  in  many  instances  the  firms 
have  volunteered  to  pay  interest  which  has  been  suspended."' 
And  in  every  case  a  reputable  house  assumes  a  moral  responsi- 
bility of  "seeing  the  clients  through"  default,  reorganization, 
etc.  It  takes  the  lead  at  its  own  expense  in  upholding  the 
mortgage  rights  and  legal  claims  of  the  bondholders. 

Bond  houses  assist  in  giving  marketability  to  securities. 
One  of  the  most  interesting  developments  in  connection  with  the 
maintenance  of  the  good  will  of  customers  is  the  practice  of 
buying  back  securities  from  those  to  whom  they  have  been  sold, 
thus  giving  to  the  securities  a  ready  marketability.  While  the 
practice  cannot  be  said  to  be  universal  and  while  circumstances 
might  alter  the  practice  of  any  given  house,  it  is  nevertheless 
customary  for  conservative  bond  houses  to  agree  to  repurchase 
securities  at  the  market  price  then  obtaining,  and  sometimes 
at  the  price  at  which  they  originally  sold.  Some  houses  state, 
"We  shall  put  our  issues  as  nearly  as  possible  on  a  plane  of 
marketability  with  active  listed  securities.  We  make  no 
promises,  but,  except  in  times  of  panic,  when  it  may  be  impos- 
sible to  raise  money  to  satisfy  everybody,  we  hope  and  expect 

'  Chamberlain,  Principles  of  B<md  Investment,  p.  522. 


242         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

to  be  so  situated  as  to  buy  back  at  the  fair  market  price  the 
securities  we  have  sold." 

The  investment  banker  also  makes  it  a  point  to  be  able  to 
supply  his  client  with  any  security  that  he  may  desire  to  pur- 
chase. K  the  stock  or  bond  required  is  one  of  which  the  house 
has  been  a  distributor,  it  will  endeavor  to  repurchase  from 
customer  B  the  securities  required  by  customer  A.  If  the 
securities  sought  by  the  customer  have  never  been  handled 
by  this  house,  it  is  necessary  for  the  banker  to  "pick  them  up" 
in  the  market.  In  order  to  repurchase  securities  once  sold  and 
to  furnish  its  customers  at  any  time  with  the  securities  required 
it  is  necessary  for  the  banking  house  to  have  funds  available 
for  the  purpose  and  to  maintain  a  "trading  position"  in  the 
investment  market.  Whenever  a  house  wishes  to  buy  or  sell 
a  few  shares  or  bonds  of  a  given  issue  it  gets  in  touch  with 
other  houses  which  may  have  such  securities  on  hand  or  may  be 
able  to  get  them  from  some  of  their  customers. 

There  are  also  street  brokers  who  make  a  small  commission 
of  1/16  or  1/8  per  cent  as  go-betweens  in  the  buying  and  selling 
of  such  securities.  In  the  ctse  of  an  active  issue  it  is  of  course 
always  possible  to  buy  and  sell  the  securities  desired  on  the 
stock  exchange.  But  the  commissions  that  must  be  paid  the 
exchange  brokers  serve  to  make  the  purchase  of  securities  on 
the  exchange  a  last-resort  measure;  it  is  usually  cheaper  to  make 
use  of  the  street  brokers. 

Investment  banks  also  act  as  financial  advisers  to  corporations. 
An  investment  bank  not  only  finances  a  corporation  in  its 
initial  stages,  at  the  time  of  its  original  organization;  it  serves 
the  company  continuously  in  connection  with  refunding  and 
expansion  operations.  The  banker  becomes  a  financial  adviser 
to  his  client.  Additional  securities  need  to  be  issued  from  time 
to  time  and  the  banker  is  in  a  position  to  recommend  favorable 
periods  for  putting  out  such  issues  and  also  to  advise  as  to  the 
best  type  of  security  to  issue  under  the  existing  circumstances. 
It  is  not  to  be  understood  from  this,  however,  that  the  larger 
corporations  depend  entirely  upon  any  one  investment  banker. 
There  is  competition  among  the  bankers  for  business;  and  the 


MARKETING  OF  mOH-GRADE  SECURITIES  243 

wide-awake  house  studies  carefully  the  financial  needs  of  the 
various  corporations,  with  a  view  to  acquiring  the  business 
of  those  which  have  maturing  obligations  to  be  refunded  or  new 
issues  to  be  sold  for  the  provision  of  additional  funds. 

Vm.    CAPITAL  REQUIREMENTS  AND  PROFITS  OF 
INVESTMENT  BANKS 

As  compared  with  manufacturing  or  producing  establish- 
ments the  capital  requirements  of  the  investment  banker  are 
relatively  small;  they  are  small  even  as  compared  with  those 
of  the  ordinary  commercial  or  savings  bank.  Since  the  invest- 
ment banker  deals  merely  in  credit  instruments  rather  than 
in  concrete  material  goods,  a  large  plant  is  obviously  unneces- 
sary; and  since  the  investing  public  is  largely  reached  by  sales- 
men and  correspondence,  the  building  and  equipment  are  small 
as  compared  with  those  of  commercial  or  savings  institutions 
whose  customers  must  frequent  the  bank.  All  that  is  needed  is 
office  space  for  those  who  are  engaged  in  the  legal,  engineering, 
accounting,  and  economic  analysis  that  is  required  and  in  the 
preparation  of  advertising  literature. 

As  the  foregoing  description  of  the  investment  business  has 
indicated,  bond  houses  are,  however,  often  required  to  invest 
their  own  funds  in  the  securities  which  they  are  handling, 
particularly  in  connection  with  the  function  of  underwriting. 
But  the  amount  of  their  own  capital  that  is  required  is  not  so 
great  as  might  be  expected,  for  the  reason  that  they  are  in  a 
position  to  borrow  heavily  from  the  commercial  banks,  using 
securities  as  collateral  for  the  loans.  For  instance,  the  under- 
writer can  borrow  from  50  to  90  per  cent  of  the  value  of  the 
securities  in  his  possession,  the  percentage  depending  upon  the 
character,  particularly  upon  the  marketability,  of  the  securities. 

The  profits  obtained  by  investment  bankers  have  evoked  much 
controversy.  There  has  been  much  discussion  of  the  profits 
made  by  investment  bankers  and  it  has  often  been  asserted  that 
the  returns  in  this  field  of  enterprise  are  exorbitant.  This 
view  is  in  part  attributable  to  a  failure  to  appreciate  that  the 


244         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

"spread"  between  the  price  paid  to  the  corporation  and  the 
price  at  which  the  securities  are  marketed  represents  gross 
rather  than  net  profits;  and  in  part  it  is  due  to  the  common 
practice  of  generalizing  on  the  basis  of  a  particular  instance  of 
handsome  profits — forgetting  the  cases  where  profits  were  low 
and  even  where  losses  were  actually  sustained.  The  truth  is 
that  the  risks  and  expenses  involved  vary  widely  with  different 
securities  and  at  different  times,  depending  upon  the  character 
of  the  security  and  the  state  of  the  investment  market. 
Accordingly  the  gross  profit,  represented  by  the  margin  between 
buying  and  selling  prices,  will  vary  markedly  with  different 
issues.    The  net  profits  also  show  extreme  variations. 

With  all  the  experience  and  skill  the  merchant  can  bring  to 
bear  on  his  purchases,  the  conditions  under  which  he  works  are  so 
complex  that  he  often  cannot  foresee  the  outcome.  If  the  hoped-for 
per  cent  of  profit  is  not  made,  the  transaction  may  turn  to  the  loss 
of  many  per  cent,  besides  the  cost  of  selling.  If  a  dealer  has  not 
been  shrewd  enough  to  sell  out  in  advance  of  falling  prices,  or  does 
not  gauge  accurately  the  duration  and  rapidity  of  the  decline,  he 
may  take  heavy  losses.  Probably  no  investment  banker  went 
through  the  transition,  from  the  period  of  rising  security  prices 
culminating  in  1905  to  the  subsequent  period  of  declining  prices 
and  the  panic  of  1907,  without  taking  large  losses.  Bonds  bought 
in  the  hope  of  selling  at  three-fourths  of  i  per  cent  above  the  price 
were  sold  at  a  loss  of  from  4  to  5  per  cent.  Except  in  the  case 
of  specialty  bonds  sold  through  a  careful  education  of  the  investor 
in  the  merits  of  the  particular  security,  a  sale  in  a  declining  market 
must  be  practically  inwaediate  in  order  to  be  really  profitable.  If  a 
dealer  misjudges  the  appetite  of  purchasers,  he  gets  "hung  up" 
with  an  issue  of  securities  which  the  investor  will  not  even  masticate, 
to  say  nothing  of  digesting. 

A  closing-up  of  the  market,  the  refusal  of  investors  to  purchase, 
is  a  common,  periodic  phenomenon,  which  becomes  particularly 
acute  in  London.  It  takes  place  whenever  investors  generally 
think  the  present  is  not  a  good  time  to  buy.  If  an  investment 
merchant  fails  to  foresee  its  coming,  he  has  to  carry  a  heavy  burden 
of  seciuities  that  he  cannot  sell.' 

» Lyon,  Corporation  Finance,  II,  58-59. 


MARKETING  OF  HIGH-GRADE  SECURITIES  245 

Granted  that  underwriters  assume  large  risks,  that  they 
may  have  to  buy  in  the  securities  at  the  price  stipulated  and 
thus  tie  up  their  own  capital  for  a  considerable  period  of  time, 
it  is  still  pertinent  to  inquire  whether  on  the  whole  they  are  not 
in  a  position  to  charge  more  than  the  risks  and  expense  and  the 
services  performed  warrant.  The  answer  to  this  inquiry  will 
obviously  depend  upon  the  extent  of  competition  among  under- 
writers. Given  competition,  one  may  be  sure  that  by  and  large 
the  returns  to  capital  will  be  no  greater  here  than  in  other 
lines  of  industry.' 

tX.    THE  REGULATION  OF  INVESTMENT  BANKING 

The  investment  banking  business  has  developed  as  a  private 
enterprise  and  has  been  subject  only  to  such  legal  control  as 
applies  to  any  corporation,  partnership,  or  individual  business. 
That  is  to  say,  the  law  of  agency,  contracts,  etc.,  relates  to 
investment  bankers  precisely  as  to  other  business.  But  except 
where  blue  sky  laws,  as  outlined  in  the  previous  chapter,  con- 
tain provisions  relating  to  securities  dealers,  there  has  been 
no  governmental  regulation  and  control  of  the  investment 
banking  business. 

So  far  as  the  rank  and  file  of  the  older  bond  houses  are  con- 
cerned there  is  probably  little  occasion  for  any  regulation 
beyond  what  is  provided  by  ordinary  legal  processes.  The 
long-established  and  conservative  bond  houses  are  very  much 
alive  to  the  necessity  of  eliminating  the  fraudulent  promoter  and 
of  safeguarding  in  every  way  their  own  reputation  for  probity 
and  conservatism.  But  the  number  of  investment  banking 
institutions  has  been  increasing  so  rapidly  in  recent  years  that 
there  is  plenty  of  opportunity  for  the  practice  of  fraud  and  for 
the  selling  of  highly  speculative  securities  by  houses  who 
trade  on  the  reputation  that  has  been  built  up  by  the  older  and 
more  conservatively  operated  institutions. 

There  is  need  of  additional  control  of  investment  hanking. 
"As  the  investment  business  is  now  organized,"  says  Paul  M. 
Warburg,  formerly  chairman  of  the  Federal  Reserve  Board, 

I  S«e  chap,  zxzi  for  a  discussion  of  the  so-called  money  trust. 


246         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

"the  writers  of  investment  circulars  may  emphasize  and  omit 
what  suits  them  best,  and  printed  underneath  their  often 
meager  and  arbitrary  annoimcement  they  insert  a  statement 
that  the  'information  is  not  guaranteed  but  is  based  on  state- 
ments from  what  they  consider  to  be  reliable  sources,'"' 

Mr.  Warburg  suggests  the  appointment  of  a  volimtary 
committee  in  each  Federal  Reserve  district, 

which  would  be  prepared  to  examine  a  prospectus  before  the  securi- 
ties are  offered,  and  would  certify  that  certain  papers  necessary  to 
authenticate  the  facts  have  been  filed  ....  that  it  is  pubUshed  over 
the  signature  and  under  the  responsibility  of  the  corporation  or 
government  issuing  the  securities,  or  of  the  investment  house  offering 
the  same  ....  and  that  important  facts  have  not  been  omitted. 
....  If  a  committee  of  this  character  were  organized,  the  public 
could  soon  be  warned  that  no  security  shovdd  be  considered  unless 
•the  prospectus  or  offering  showed  the  certification  number  of  the 
securities  committee  of  the  district. 

Unless  something  of  this  sort  be  done,  it  is  only  a  question  of  time 
for  some  grave  disappointments  or  scandals  to  occur,  discrediting 
future  issues  and  interfering  with  the  free  and  healthy  development 
of  our  security  markets.  If,  on  the  other  hand,  the  strong  and 
reputable  investment  houses,  of  their  own  accord,  subject  themselves 
to  whatever  little  delay  and  red  tape  may  be  necessary  in  dealing 
with  their  issues,  they  will,  in  the  long  run,  best  protect  their  own 
interests.  Because  in  doing  so  they  will  help  in  keeping  the  crook 
out  and  preserve  a  clear  field  for  those  who  are  not  afraid  to  have 
the  searchlight  turned. upon  the  securities  they  are  about  to  offer. 

It  wDl  be  seen  that  the  argument  for  the  regulation  of  invest- 
ment banking  is  not  that  all  investment  banking  houses  require 
close  supervision,  but  only  that  some  of  them  do;  and  in  order 
to  make  sure  that  these  shall  be  effectively  regulated  it  is 
beheved  that  all  houses  should  gladly  submit  to  regulation — 
either  by  a  committee  appointed  by  themselves  or  by  some 
governmental  agency.  As  has  been  the  case  with  private  com- 
mercial bankers  in  times  gone  by,  there  will  be  many  efficient 

•  From  an  address  by  Paxil  M.  Warburg,  delivered  before  the  Bond 
Club  of  New  York,  May  »3, 1919, 


MARKETING  OF  HIGH-GRADE  SECURITIES  247 

and  time-tried  investment  bankers  who  will  oppose  such  regu- 
lation as  an  unwarranted  interference  with  private  initiative 
and  as  entirely  unnecessary  in  their  particular  cases.  But,  as 
has  been  the  case  with  the  commercial  banks  and  other  financial 
institutions,  there  will  nevertheless  be  a  gradual  extension  of 
the  scope  of  investment  banking  regulation.  And  it  should  be 
welcomed  by  the  conservative  institutions;  for  the  general  plane 
upon  which  the  investment  banking  business  is  conducted  may 
thereby  be  substantially  raised.  All  houses  may  well  be  com- 
pelled to  meet  at  least  certain  minimum  requirements  which 
have  been  found  to  be  indispensable  to  efficient  investment 
banking. 

X.    INVESTMENT  BANKS  AND  THE  GENERAL 
ECONOMIC  ORGANIZATION 

We  have  thus  far  been  discussing  the  nature  of  the  opera- 
tions engaged  in  and  the  services  performed  by  investment 
banks,  with  only  incidental  reference  to  the  social  importance 
of  such  institutions.  It  remains  to  indicate  the  larger  signifi- 
cance of  investment  banking  houses,  in  relation  to  the  general 
economic  organization  of  the  present  time. 

Investment  bankers  assist  in  directing  the  distribution  of 
industrial  energy.  In  the  first  place,  investment  bankers  play 
a  dominant  role  in  directing  the  flow  of  capital  and  labor 
between  different  industries  and  between  different  establish- 
ments in  any  given  industry.  As  the  economic  system  is  now 
organized,  business  managers  reach  a  tentative  judgment  that 
the  development  of  a  new  industry  or  the  construction  of  an 
additional  plant  within  an  existing  industry  will  prove  profitable. 
The  proposal  for  an  issue  of  securities  as  a  means  of  raising  the 
necessary  capital  is  then  submitted  to  the  investment  banker 
for  approval.  Since  the  banker  occupies  a  detached  position 
and  since  he  will  suffer  financial  loss  as  well  as  a  lessening  of 
his  reputation  for  sound  and  conservative  judgment  if  his 
estimate  of  the  proposition  proves  in  error,  he  may  be  counted 
on  to  bring  to  bear  in  his  investig^-tjon  and  analysis  all  the 


248        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

technical,  legal,  and  accounting  knowledge  and  economic 
prescience  that  can  be  mustered.  There  is  thus  every  incentive 
to  make  the  investigation  as  comprehensive  and  as  penetrating 
as  possible. 

Every  year  a  great  many  hopeful  enterprises  are  denied 
funds  by  those  who  hold  the  purse  strings.  And  while  mistakes 
are  often  made,  there  is  little  question  but  that  the  veto  power 
resting  in  the  hands  of  the  investment  bankers  prevents  each 
year  much  dissipation  of  capital  in  fruitless  ventures.  It  is, 
of  course,  always  possible,  in  the  event  a  given  enterprise  is 
turned  down  by  the  conservative  investment  banking  houses,  to 
float  the  securities  without  bankers'  assistance,  through  the 
processes  described  in  the  preceding  chapter.  But  despite  this 
possibility,  it  remains  true  that  the  conservative  bond  house, 
by  virtue  of  its  strategic  position  in  the  investment  market, 
is  a  dominating  factor  in  the  distribution  of  social  energy.  It 
will  be  noted  that  a  banking  house  may  deny  an  enterprise 
funds  because  the  men  who  are  back  of  it  are  lacking  in 
integrity  or  business  ability,  as  well  as  because  the  enterprise 
does  not  promise  well  from  a  business  standpoint.  The  invest- 
ment banking  houses  thus  tend  to  insure  both  that  the  manage- 
ment of  industries  shall  be  in  the  hands  of  honest  and  able 
men,  and  that  social  energy  shall  be  directed  into  the  most 
profitable  channels. 

Under  the  conditions  imposed  by  the  gigantic  scale  on 
which  industry  is  now  conducted,  control  of  the  distribution 
of  capital  is  a  task  of  paramount  importance.  Because  of  the 
great  quantity  of  fixed  capital  required,  the  waste  of  social 
energy  entailed  is  enormous  whenever  an  industry  proves 
unprofitable  or  a  large  enterprise  in  any  given  industry  goes  on 
the  financial  rocks. 

Investment  banking  lessens  the  cost  of  prodticing  goods.  In 
the  second  place,  the  investment  banker  reUeves  the  borrowing 
corporation  of  a  very  difficult  and  expensive  task,  that  of  rais- 
ing the  funds  required  for  its  operations.  It  is  conceivable 
that  a  corporation,  however  large,  might  take  care  of  its  own 
financing — that  is,  issue  its  own  securities,  send  out  adver- 


MARKETING  OF  fflGH-GRADE  SECURITIES  249 

tising  literature  and  salesmen,  and  await  the  inflow  of 
funds  from  ultimate  investors  before  beginning  its  business 
activities.  Most  corporations  are,  however,  poorly  equipped 
for  the  marketing  of  securities,  and  the  costs  involved  would 
be  much  greater  to  them  than  to  a  regularly  organized  bond 
house. 

The  advantages  possessed  by  an  institution  that  specializes 
in  the  raising  of  capital  are  obvious  enough.  First,  it  has 
a  great  deal  of  skill  in  advertising  and  salesmanship,  which  can 
be  acquired  only  as  a  result  of  repeated  experiences  in  such  work. 
In  the  nature  of  things  the  acquisition  of  such  skill  is  out  of  the 
question  for  a  corporation,  which  has  the  task  of  raising  capital 
only  periodically,  perhaps  two  or  three  times  in  a  generation. 
It  should  be  observed  that,  under  these  circumstances,  it  would 
not  be  feasible  for  a  corporation  to  have  a  specialized  "capital- 
raising  department"  as  a  permanent  part  of  its  organization. 
It  must  accordingly  either  use  relatively  unskilled  officials  for 
the  task  of  raising  capital  or  employ  (at  high  cost)  specialists 
whenever  the  necessity  arises.  Second,  a  bond  house  can  do 
much  of  its  advertising  of  any  particular  issue  along  with  other 
issues^  thus  dividing  the  advertising  expense  involved.  In 
addition  to  the  disadvantages  inherent  in  raising  its  own 
capital,  the  corporation  usually  finds  that  the  task  of  organizing 
the  business  and  making  preparation  for  an  effective  utilization 
of  the  funds  to  be  raised  requires  its  full  energy. 

In  the  third  place,  and  of  even  greater  significance,  the 
investment  bankers  make  it  possible  for  a  corporation  to 
enter  into  contracts  and  to  proceed  with  the  development  of 
its  business  in  the  light  of  definite  knowledge,  both  as  to  the 
amount  of  the  funds  that  will  be  received  and  as  to  the  time  at 
which  they  will  be  available.  The  investment  market  is 
capricious;  securities  may  be  sold  quickly — ppssibly  sooner 
than  is  necessary  for  the  purposes  of  the  corporation — and  at  a 
favorable  rate;  or  it  may  be  that  years  will  be  required  for  their 
final  absorption  by  investors,  and  that  the  price  at  which  they 
can  be  sold  will  be  much  below  what  the  corporation  had 
estimated.    But  the  underwriters,  as  we  have  seen,  guarantee 


25©         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

to  the  corporation  a  definite  amount  of  funds  at  a  definite 
time.  If  a  corporation  did  not  know  in  advance  what  the 
total  quantity  of  funds  would  be,  it  could  not  be  certain, 
when  making  contracts  incident  to  the  development  of  the 
enterprise,  that  such  contracts  could  be  carried  out.  And 
if  it  did  not  know  when  its  financial  resources — ^whatever  the 
total  amount — would  be  available,  it  would  have  no  assurance 
that  its  contracts  could  be  fulfilled  promptly  or  that  production 
could  be  carried  out  according  to  schedule.  Indeed,  the  risks 
involved  here  would  be  so  great  that  many  an  enterprise 
partly  launched  would  have  either  to  curtail  its  operations  or 
else  completely  wind  up  its  affairs,  owing,  not  to  any  funda- 
mental weakness  on  the  part  of  the  enterprise,  but  only  to  the 
exigencies  of  the  investment  market.  Such  failures  carry  in 
their  train  a  great  waste  of  industrial  resources. 

What  has  been  said  above  with  reference  to  the  advantages 
that  investment  banks  confer  upon  corporations  amounts 
merely  to  saying  that  the  underwriting  and  distributing  func- 
tions serve  to  reduce  substantially  the  cost  of  raising  capital 
required  by  modem  large-scale  enterprise.  This  reduction  in 
the  cost  of  capital-raising  makes  it  possible  for  enterprises  to 
produce  more  cheaply  than  would  otherwise  be  the  case  and, 
where  competition  prevails,  the  result  is  a  lower  selling  price 
for  the  commodities  than  would  otherwise  obtain. 

Investment  bankers  are  financial  edttcators.  In  the  fourth 
place,  the  investment  banking  institutions  render  a  social 
service  of  inestimable  value  in  educating  the  general  public 
along,  financial  lines.  Were  it  not  for  the  investment  educa- 
tion that  has  been  given  to  the  American  people  by  invest- 
ment bankers,  through  conversations  with  clients,  actual 
and  prospective,  through  general  advertising  Uterature,  and 
through  folders  and  circulars  which  discuss  investment  prin- 
ciples, it  is  not  improbable  that  the  annual  losses  in  this  country 
from  fraudulent  and  worthless  investments  would  be  many 
times  their  present  staggering  total. 

Quite  as  important  from  the  standpoint  of  economic  develop- 
ment is  the  emphasis  that  has  been  placed  by  investment 


MARKETING  OF  mGH-GRADE  SECURITIES  251 

bankers  upon  the  necessity  for  thrift.  Where  the  pubhc 
schools,  the  daily  press,  and  the  magazines  of  the  country  have 
been  generally  silent  on  the  subject,  the  investment  bankers 
have  been  urging  the  national  importance  of  eliminating  waste- 
ful and  unnecessary  expenditures  of  income  in  order  to  make 
provisions  for  the  proverbial  rainy  day,  and  the  necessity  of 
supplying  through  "saving"  the  funds  required  for  the  develop- 
ment of  new  and  the  expansion  of  the  existing  industrial  facihties 
of  the  country. 

QUESTIONS  FOR  DISCUSSION 

I.  THE  DEVELOPMENT  OF  INVESTMENT  BANKING 

1.  What  were  the  chief  sources  of  demand  for  capital  in  medieval 
times?    How  were  these  demands  met? 

2.  When  did  investment  banking  have  its  origin  in  the  United 
States  ?    When  was  its  period  of  greatest  development  ? 

3.  Why  did  the  development  of  investment  banking  institutions 
wait  upon  the  growth  of  the  corporate  form  of  industry  ? 

4.  Can  you  suggest  any  handicaps  to  private  enterprise  before 
the  development  of  investment  banking  houses  ?  to  government 
enterprise  ? 

5.  The  first  stage  of  railway  development  in  the  United  States  was 
carried  out  by  government  rather  than  by  private  enterprise. 
It  has  been  suggested  that  this  was  because  of  the  impossibility 
of  raising  the  necessary  capital  without  the  aid  of  the  govern- 
ment. Might  the  absence  of  investment  banks  in  the  early  days 
have  had  some  bearing  on  this  ? 

6.  In  the  light  of  your  knowledge  of  our  industrial  development 
suggest  the  order  in  which  the  various  types  of  specialized 
investment  houses  probably  originated. 

7.  "The  one  big  task  of  investment  bankers  is  to  bridge  the  gap 
between  investors  and  borrowers — to  raise  funds  from  a  multitude 
of  individual  and  institutional  investors  and  turn  them  over  to 
corporations  and  governments  who  are  in  need  of  them."  Into 
what  secondary  functions  is  this  task  divided  ? 

8.  Study  the  chart  on  page  218  and  enumerate  as  many  different 
groups  of  people,  organizations,  and  institutions  as  you  can  that 
are  interested  in  or  dependent  upon  investments. 

9.  Consult  an  official  of  a  local  bond  house  or  commercial  bank  and 
ascertain  what  functions  his  institution  participates  in. 


252         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

10.  Ascertain,  by  local  inquiry,  how  many  different  tyi>es  of  securi- 
ties are  handled  by  a  given  investment  institution. 

11.  Ascertain,  by  local  inquiry,  how  the  smaller  corporations  in  the 
community  have  raised  their  capital. 

n.     INVESTIGATION  AND  ANALYSIS 

12.  Which  of  the  various  types  of  securities — government,  railway, 
public  utility,  and  industrial — do  you  think  present  the  most 
difficult  problems  of  analysis  ? 

13.  Study  carefully  the  chart  depicting  the  various  aspects  of  the 
problem  of  bond  values.  Classify  the  different  questions  in  the 
order  of  their  difficulty  of  correct  appraisal.  Which  do  you 
regard  of  greatest  importance  ? 

14.  What  is  meant  by  the  "equity"  ?  How  much,  if  any,  in  excess 
of  the  amount  of  the  bond  issue  should  the  equity  of  a  company 
be?  (Refer  back  to  provisions  affecting  Class  B  under  the 
Illinois  Securities  Law.) 

15.  "In  analyzing  an  income  accoimt  one  must  observe,  particularly, 
the  excess  of  the  total  net  earnings  above  the  amount  of  the 
interest  on  bonds;  and  in  the  case  of  stocks  above  the  amount 
of  the  dividend  payments."    Why  ? 

16.  Enumerate  as  many  factors  as  you  can  which  might  affect  the 
"condition  of  the  money  market"?  the  general  industrial 
situation  ? 

17.  Draw  up  in  outline  form  what  you  think  would  be  a  necessary 
course  of  study  for  one  who  hoped  to  be  a  successful  analyst  of 
investment  values. 

18.  What  is  meant  by  a  house  of  original  purchase  or  issue  ?  May 
any  house  make  an  original  purchase  ? 

ig.  What  sort  of  houses  tend  to  specialize  somewhat  in  investigation 
and  first  purchase  ? 

20.  The  original  purchasers  are  sometimes  called  wholesale  concerns. 
Do  you  think  this  is  a  correct  description  of  their  activities? 
Do  they  have  anything  to  say  about  the  terms  on  which  the 
.retailing  is  to  be  effected  ? 

DDE.     THE  UNDERWRITING  FUNCTION 

21.  What  is  the  practical  necessity  for  underwriting?  Is  there  a 
greater  necessity  with  large  than  with  small  undertakings  ? 

22.  May  a  single  house  underwrite  an  entire  issue? 


MARKETING  OF  HIGH-GRADE  SECURITIES  253 

25.  What  would  determine  whether  a  given  issue  would  be  handled 
by  an  individual  house  or  on  joint -account  ? 

24.  What  is  the  difference  between  a  joint-account  and  a  syndicate 
operation  ?    What  would  determine  which  would  be  used  ? 

25.  In  the  case  of  a  joint -account  do  the  associated  houses  merely 
underwrite  the  issue  ?    Who  sells  it  ? 

26.  What  factors  would  determine  the  choosing  of  houses  for  a 
joint-account  participation  ? 

27.  When  a  syndicate  is  formed,  is  it  merely  for  the  purpose  of 
underwriting  an  issue  ? 

28.  Show  concretely  how  a  house  of  original  purchase  may  contract 
itself  out  of  the  risks  of  underwriting  through  the  organization 
of  a  syndicate, 

29.  Is  it  fair  for  a  house  of  original  purchase  to  take,  say,  $1.00  per 
share  for  its  work?  Precisely  what  is  the  work  for  which  it 
receives  this  $1 .  00  per  share  ? 

30.  "The  houses  of  first  purchase  do  not  assume  any  risks."  Do 
you  agree  ? 

31.  "It  is  usually  good  policy  for  a  very  large  investment  house  to 
form  an  underwriting  syndicate,  even  though  its  resources 
be  sufficient  to  swing  the  entire  amount,  because  it  is  safer 
to  underwrite  5  per  cent  of  twenty  different  issues  totaling 
$100,000,000  than  100  per  cent  of  a  single  $100,000,000  issue." 
If  so,  why  ? 

32.  Is  it  possible  for  a  house  to  secure  the  profits  incident  to  original 
purchase  in  a  larger  number  of  issues,  if  it  does  not  tie  up  its 
full  resources  in  underwriting  a  single  issue  ? 

i^.  Do  you  understand  that  an  underwriting  syndicate  is  a  permanent 
organization  ? 

34.  Define:  participation,  subscription,  allotment,  "canying  securi- 
ties." 

35.  Is  it  necessary  for  underwriters  who  participate  in  an  issue  that 
is  brought  out  by  a  house  or  group  of  original  purchasers  to  make 
an  investigation  of  the  enterprise? 

36.  Do  the  original  purchasers  also  participate  in  the  underwriting  ? 
Do  you  fancy  that  in  practice  every  imderwriting  participant 
makes  an  independent  analysis  ? 

IV.     THE  DISTRIBUTION  FUNCTION 

37.  Enumerate  as  many  sources  of  demand  for  investment  securities 
as  possible.    Which  would  be  the  most  easily  reached  ? 


254         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

38.  "A  bond  well  purchased  is  half  sold."    What  does  this  mean? 

39.  "The  distributing  houses  do  not  assume  any  risks."  Do  you 
agree? 

40.  Work  out  the  steps  involved  in  an  issue  of  one  million  dollars  of 
bonds  of  Corporation  X.  Use  actual  figures  and  indicate  the 
division  of  the  proj&ts  as  between  original  purchasers,  xmder- 
writers,  and  distributors.  Sell  the  same  issue  at  a  loss  and 
indicate  the  distribution  of  the  losses. 

41.  Does  the  typical  letter  to  potential  purchasers  giveji  on  page  239 
furnish  sufficient  data  for  a  reliable  judgment  ? 

42.  What  is  the  purpose  of  "buying  back"  securities?  Of  what 
advantage  is  it  to  the  individual  investor  ?  Do  you  fancy  many 
people  would  not  buy  "unlisted  securities"  if  it  were  not  for  the 
marketability  given  to  them  by  the  willingness  of  the  bond 
houses  to  buy  them  back  ? 

43.  What  is  the  function  of  the  "street  brokers"  ?  Aje  they  "profi- 
teering" middlemen,  or  do  they  render  a  service  greater  than 
the  amoxmt  of  the  commissions  ? 

44.  Why  cannot  a  bond  house  guarantee  bonds?  How  can  it 
usually  assxime  the  losses,  in  actual  practice  ? 

45.  For  what  purpose  does  an  investment  bank  need  fixed  capital? 
working  capital  ? 

46.  In  connection  with  which  function  is  the  largest  amount  of  capital 
required  ? 

47.  What  other  financial  institutions  are  necessary  in  order  to 
enable  the  investment  banker  to  engage  in  underwriting  on  a 
large  scale  ? 

48.  Is  it  necessary  for  the  houses  of  distribution  to  have  connections 
with  commercial  banks  ? 

49.  What  determines  the  amount  of  profit  an  investment  bank  can 
make:  (a)  as  a  distributor  of  securities;  (6)  as  an  underwriter; 
(c)  as  original  pxirchaser  ? 

50.  "The  investment  banker  must  charge  enough  more  than  the 
expenses  involved  to  compensate  for  the  risks  assumed  and 
obtain  a  profit."  Does  this  mean  that  the  costs  involved  to 
the  corporation  in  raising  its  capital  are  greater  than  they  would 
be  if  raised  directly  by  the  corp>oration  itself  ? 

51.  Do  you  see  any  dangers  in  leaving  investment  banks  imregu- 
lated  ?    Would  you  favor  federal  incorporation  ? 

52.  Write  a  summary  of  the  social  benefits  of  the  investment  banking 
business. 


MARKETING  OF  fflGH-GRADE  SECURITIES  255 

53.  How  do  you  account  for  the  development  of  the  investment 
banking  business  ?  Did  society,  in  any  organized  capacity,  have 
anything  to  do  with  it? 

54.  In  the  exercise  of  his  veto  power  over  the  development  of  a 
given  enterprise,  is  the  investment  banker  actuated  by  consider- 
ations of  social  well-being?  What  is  the  test  on  which  he  bases 
his  decision  ? 

55.  In  a  socialistic  society  how  would  the  distribution  of  industrial 
energy  between  different  industries  be  determined?  between 
different  establishments  in  a  given  industry  ?  Can  you  suggest 
any  possible  shortcomings  in  this  method  ? 

REFERENCES  FOR  FURTHER  READING 

Annals  of  the  American  Academy  of  Political  and  Social  Science, 
Vols.  XXX  and  XLII. 

Bulletins  of  the  Investment  Bankers'  Association  of  America. 

Chamberlain,  Lawrence:  Principles  of  Bond  Investment,  191 1, 
chap.  xl. 

Gerstenberg,  Charles  W.:  Materials  of  Corporation  Finance, 
PP-  374-76;  404-11. 

Lough,  William  H.:  Business  Finance,  191 7,  chaps,  xiv  and  xv. 

Lyon,  Hastings:  Corporation  Finance,  1916,  chaps,  ii  and  iii. 


CHAPTER  XV 

FOREIGN  INVESTMENT  TRUSTS 

The  marketing  of  investment  securities,  as  discussed  in 
the  preceding  chapter,  related  primarily  to  the  placing  of 
domestic  issues  in  the  American  investment  market,  with  only 
incidental  reference  to  the  marketing  of  securities  abroad 
through  the  participation  of  foreign  bankers  in  American 
syndicates.  The  placing  of  investments  in  foreign  markets 
gives  rise  to  problems  of  peculiar  difficulty,  owing  to  the  risks 
and  uncertainties  involved  in  loaning  at  great  distances.  It  is 
the  purpose  of  this  chapter  to  describe  the  investment  ma- 
chinery that  has  been  developed  by  other  countries  to  meet 
these  difficulties  and  to  indicate  the  problems  that  now  con- 
front the  United  States  in  this  connection. 

Great  Britain  has  investments  all  over  the  world.  Great 
Britain  has  for  so  many  years  been  the  financial  center  and  the 
great  creditor  nation  of  the  world  that  a  brief  statement  of 
British  overseas  financial  relations  will  best  reveal  the  nature 
of  the  problem.  There  are  now  listed  on  the  London  Stock 
Exchange  1,156  foreign  and  colonial  securities,  classified  as 
follows:  colonial  and  provincial  government,  185;  Indian  and 
colonial  city,  176;  foreign  city,  76;  foreign  government,  210; 
railways  in  British  colonial  possessions,  no;  Indian  railways, 
68;  American  railroad  securities,  56;  foreign  railways,  276. 
These  foreign  issues  appear  to  be  substantially  in  excess  of 
the  domestic  securities  traded  in  on  the  London  exchange. 

The  distribution  of  British  foreign  investments  in  1913  has 
been  estimated  as  follows:  railways,  $7,402,014,631.50; 
governments,  $4,669,518,679.50;  mines,  $1,327,527,668.50; 
financing  land  investments,  $1,188,336,035.50;  municipal, 
$718,037,475.00;  commerce  and  industrial,  $707,258,178.00; 
tramways,  $378,565,035.00;  banks,  $345,811,648.50.  Of  the 
total,  $8,662,345,667 .  50  were  invested  in  India  and  the  British 

256 


FOREIGN  INVESTMENT  TRUSTS  257 

colonies.  The  United  States  stood  next  with  $3,672,343,630. 50; 
with  Argentina  a  good  third  at  $1,555,163,072.50,  Nearly 
every  country  in  the  world  was  represented,  in  amounts  varying 
from  $30,000,000 .00  in  the  case  of  Germany,  to  $718,000,000 .00 
in  the  case  of  Brazil.  The  grand  total  of  British  foreign  invest- 
ments was  placed  at  $18,075,441,423.50,  exclusive  of  a  large 
amount  of  capital  privately  loaned  abroad,  estimated  to  equal 
about  $1 ,400,000,000 .  00. 

These  vast  investments  have  afforded  a  highly  profitable 
outlet  for  British  savings,  which  could  be  reinvested  in  Great 
Britain  only  under  conditions  of  substantially  diminishing 
returns.  They  have  also  made  possible  the  development  of  the 
railroad  systems  of  the  United  States,  the  Argentine,  Australia, 
etc.,  and  have  thus  opened  up  for  cultivation  in  all  portions 
of  the  world  vast  tracts  of  rich  agricultural  lands  that  must 
otherwise  have  long  remained  unused.  They  have  furnished 
the  funds  necessary  for  exploiting  immense  stores  of  minerals  and 
raw  materials,  thus  tremendously  augmenting  the  producing 
power  of  the  world.  Sir  George  Paish  has  estimated  that  the 
increase  in  the  annual  production  of  wealth  in  the  United  States 
made  possible  by  the  investment  of  foreign  capital  here  has 
been  at  least  twenty  times  the  sum  paid  in  the  way  of  interest. 

I.    BRITISH  INVESTMENT  TRUSTS 

The  overseas  investments  of  Great  Britain  have  largely 
been  effected  by  means  of  the  investment  trust,  an  institution 
that  has  been  developed  during  the  past  twenty-five  years. 
Because  of  the  long-range  investigation  that  is  involved  it  is 
usually  impossible  for  the  foreign  investor  to  form  an  adequate 
judgment  of  the  value  of  securities;  moreover,  the  very  fact 
of  a  "foreign"  investment  leads  to  timidity.  It  was  to  over- 
come this  difficulty,  as  well  as  to  permit  the  diversification  of 
investments,  and  thus  minimize  the  risks  involved,  in  a  manner 
shortly  to  be  described,  that  the  investment  trust  was  developed. 

This  institution  is  based  on  the  law  of  averages;  that  is,  on 
the  principle  that  in  a  group  of  well-selected  securities  there 


258         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

will  be  only  a  few  which  will  result  in  losses  to  investors.  Hence 
if  a  large  number  of  investors  can  get  together,  form  an  organiza- 
tion to  make  a  thoroughgoing  investigation  of  the  corporations 
whose  securities  seem  attractive  for  purchase,  and  with  com- 
bined funds  buy  shares  in  a  large  number  of  companies,  the 
risks  of  loss  to  any  one  individual  will  be  greatly  reduced. 

Individuals  may  diversify  their  risks  by  direct  investments 
in  the  capital  of  investment  trusts,  or  they  may  purchase  as 
outsiders  the  obligations  of  these  trusts,  secured  by  the  invest- 
ments that  the  trust  has  made.  Each  of  these  methods  may 
be  briefly  considered. 

Under  the  first  method  the  shareholders,  or  partners,  as 
the  case  may  be,  are  part  owners  of  all  the  trust's  holdings 
and  are  thus  entitled  to  pro  rata  participation  in  the  aggregate 
earnings.  The  trust  organization  has  thus  made  possible  a 
co-operative  investigation  of  foreign  enterprises  which  reduces 
the  costs  of  investigation  and  gives  to  each  individual  investor 
the  benefit  of  the  investment  experience  of  the  officials  of  the 
company. 

Under  the  second  method  the  securities  purchased  are  held 
"in  trust"  by  the  company  and  replaced  by  its  own  obligations 
for  the  purpose  of  sale  to  individual  investors.  The  individual 
thus  purchases  the  obligation  of  a  well-known  domestic  financial 
institution,  rather  than  one  of  a  relatively  little-known  foreign 
corporation.  His  security  is  in  effect  the  combined  earnings 
of  all  the  companies  whose  issues  are  held  by  the  trust,  in 
addition  to  the  resources  of  the  trust  itself. 

The  trusts  are  usually,  though  not  always,  organized  on  a 
corporate  basis.  The  size  of  the  trusts  in  England,  as  also  in 
Scotland,  Belgium,  Switzerland,  Holland,  and  Germany,  is 
usually  not  very  large.  The  largest  in  Great  Britain,  for 
instance,  is  the  British  Investment  Trust,  Limited,  of  Edin- 
burgh, which  had  on  the  date  of  its  last  report  $9,300,000  of 
4  per  cent  debenture  stock  (ordinary  bonds),  $6,000,000 
of  5  per  cent  preference,  or  preferred  stock,  and  $4,000,000  of 
ordinary  or  common  stock.* 

'  The  total  capital  of  the  investment  tnists  of  Great  Britain  is  about 
$350,000,000. 


FOREIGN  INVESTMENT  TRUSTS  259 

The  "trtist"  makes  possible  a  very  wide  diversification  of  risks. 
The  nature  of  the  diversification  that  is  secured  by  these 
institutions  may  best  be  appreciated  by  actual  reference  to  the 
capital  holdings  of  some  of  the  leading  British  trusts.  The 
Investment  Trust  Corporation,  Limited,  of  London,  for  example, 
shows  in  its  statement  for  191 7  investments  in  315  different 
securities;  the  Second  Edinburgh  Investment  Trust,  Limited, 
of  Edinburgh,  for  the  same  year  had  235,  and  the  Metropolitan 
Trust  Company,  Limited  of  London,  220.'  Nearly  half  of  the 
investments  of  the  MetropoUtan  Trust  Company  were  railways 
and  street  railways.  About  a  fifth  were  government  issues, 
in  which  there  had  been  a  considerable  gain  due  to  subscriptions 
for  the  successive  British  war  loans.  The  rest  were  in  the 
securities  of  commercial  and  industrial  concerns,  electric  light- 
ing plants,  and  other  pubHc  works,  and  in  the  issues  of  other 
investments  trusts.  No  less  interesting  than  their  industrial 
diversification  was  their  distribution  by  countries.  More 
than  a  third  were  in  the  United  States,  although  the  Metro- 
politan Trust,  like  other  foreign  investors,  had  sold  back  to 
this  country  many  of  our  own  securities  early  in  the  war. 
More  than  a  fourth  of  the  investments  were  at  home  (an 
abnormal  war  condition),  but  the  remainder  were  spread  out 
over  the  growing  parts  of  the  world,  the  countries  represented 
in  the  order  of  the  amount  of  funds  they  have  attracted  from 
this  one  investment  trust  being:  the  Argentine,  British  colonies 
and  dependencies,  Brazil,  Mexico,  Central  America,  other 
South  American  countries,  the  PhiHppine  Islands,  Cuba,  and 
other  countries.  The  captain  of  this  investment  ship  is  now 
turning  his  eyes  to  the  East  and  to  Africa.' 

It  is  of  interest  to  note  that  certain  of  our  American  railroads 
have  been  largely  owned  in  the  past  by  these  EngUsh  trusts, 
while  one  American  industrial  companj'  has  been  distinguished 
by  having  its  securities  in  the  boxes  of  twenty-one  different 
English  trusts. 

'  Foreign  Financing  under  the  Edge  Act,  a  pamphlet  published  by  the 
Guaranty  Trust  Company  of  New  York. 

'  Adapted  from  "  Introducing  American  Investors  to  the  Investment 
Trust,"  The  World's  Work,  July,  iqiq. 


26o         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

There  are  some  trusts  which  specialize  geographically,  as  in 
Russian,  South  American,  or  Oriental  enterprises.  And  there 
are  others  which  devote  themselves  entirely  to  the  securities  of  a 
particular  industry,  endeavoring  to  reduce  the  risks  not  so  much 
by  extensive  diversification  as  by  intensive  analysis  of  the 
status  of  the  issuing  concern. 

n.    THE  SHIFT  IN  AMERICA'S  FINANCIAL 
POSITION 

Throughout  the  nineteenth  century,  and  in  only  lessened 
degree  in  the  first  decade  of  the  twentieth  century,  the  United 
States  was  a  leading  market  for  the  capital  of  the  Old  World, 
the  great  development  era  in  this  country  requiring,  as  already 
noted,  more  funds  than  could  be  provided  from  local  savings. 
But  the  Great  War  suddenly  changed  the  financial  balance  of 
the  world.  The  economic  requirements  of  the  war  were  such 
that  it  was  necessary  for  France  and  England,  particularly, 
to  utilize  their  past  investments  as  a  means  of  buying  supplies 
from  the  United  States;  and  a  large  percentage  of  the  total 
of  American  securities  held  in  Europe  was  re-sold  to  the  United 
States  during  the  first  two  years  of  the  war. 

After  the  United  States  entered  the  conflict  we  also  made 
loans  to  the  Allies  to  the  extent  of  nearly  $9,000,000,000,  a 
sum  which  has  been  increased  since  the  armistice  to  approxi- 
mately $10,000,000,000.  The  events  of  the  war  thus  made  of 
the  United  States  a  creditor  nation;  and  in  the  view  of  many 
this  country  is  to  be  the  future  "banker  of  the  world."  The 
thought  behind  this  contention  is  that  the  tremendous  drain 
upon  European  financial  and  economic  resources  has  rendered 
it  impossible  for  the  nations  of  Europe  to  make  large  external 
loans  for  many  years  to  come.  On  the  contrary,  it  is  urged  that 
because  of  the  great  reduction  in  European  supplies  both  of 
raw  materials  and  capital  goods,  it  is  imperative  that  the 
European  nations  assume  the  role  of  borrowing  rather  than 
lending  nations.  And  the  only  important  source  of  capital 
supply  is  in  the  United  States, 


FOREIGN  INVESTMENT  TRUSTS  261 

European  reconstruction  was  dependent  upon  American  loans. 
The  agitation  for  the  extending  of  great  loans  to  Europe  for 
reconstruction  purposes,  both  in  the  form  of  goods  sold  on  long- 
time credit  and  by  purchases  of  the  securities  of  European 
governments  and  railways,  public  utility  and  industrial  enter- 
prises, began  immediately  after  the  armistice  was  signed. 
Close  students  of  the  question,  both  in  the  United  States  and 
abroad,  early  felt  that  the  task  of  European  reconstruction 
would  be  extremely  difficult,  if  not  impossible,  without  the 
financial  and  material  aid  of  this  country,  and  large  foreign 
loans  were  repeatedly  urged  by  numerous  financial  writers. 
But  like  other  reconstruction  proposals,  the  matter  was  allowed 
to  drift  throughout  the  winter  and  spring  of  191 9. 

Upon  the  return  of  Mr.  Vanderlip,  then  president  of  the 
National  City  Bank  of  New  York,  from  an  extended  investi- 
gation of  European  financial  and  economic  conditions,  in  May, 
19 19,  the  need  of  extending  financial  assistance  to  Europe  was 
strikingly  presented,  both  in  a  public  address  in  New  York  and 
in  an  interesting  small  volume  entitled  What  Happened  to 
Europe.  Mr.  Vanderlip 's  view  in  brief  was  that  if  Europe 
were  to  recover  from  the  enormous  losses  of  the  war  and  escape 
a  complete  political  and  social  collapse,  it  was  imperative  that 
the  wheels  of  industry  be  everywhere  started  immediately, 
something  which  could  be  accomplished  only  by  means  of  a 
vast  loan  from  the  United  States.  But  since  the  securities  of 
individual  European  enterprises  would  not  find  a  ready  market 
with  American  investors,  and  since  every  portion  of  Europe 
must  be  given  assistance  if  the  specter  of  bolshevism  were  to 
be  effectively  laid,  there  must  be  a  pooling  of  all  European 
resources,  whereby  one  gigantic  loan  might  be  extended  to 
Europe  as  a  whole,  secured  by  the  joint  guaranty  of  the  Euro- 
pean governments,  with  liens  upon  customs  revenues.  Even 
then,  Mr.  Vanderlip  believed,  the  loan  would  have  to  be 
marketed  indirectly,  through  having  our  government  issue  its 
own  bonds,  backed  by  these  European  securities  as  collateral. 

Such  a  scheme  would  obviously  require  a  mobilization  of 
world  financial  resources  on  a  scale  hitherto  undreamed  of. 


262        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

While  it  challenged  the  imagination  of  many  American  business 
men  and  financiers,  it  nevertheless  appeared  to  be  so  gigantic  in 
its  nature  and  so  difficult  of  accomplishment  that  little  headway 
was  ever  made  with  the  plan.  It  will  be  noted  that  it  would 
involve,  among  other  things,  the  peaceful  co-operation  of  the 
former  Central  Powers  with  the  Allies  and  the  United  States, 
under  an  arrangement  which  could  not  possibly  satisfy  the 
nationalistic  ambitions  of  all  the  parties  to  the  proposed  contract. 

Falli.ig  exchange  rates  finally  led  to  constructive  legislation. 
It  was  repeatedly  pointed  out  by  financiers  and  economists 
throughout  the  spring  and  summer  of  191 9  that  a  gradual  fall 
in  exchange  rates  would  sooner  or  later — and  sooner  rather  than 
later — cause  a  sharp  curtailment  in  our  exports  to  European 
nations.  The  bearing  of  depreciated  exchanges  upon  foreign 
trade  is  not  difficult  to  see.  If  French  exchange,  for  example, 
is  quoted  at  10. 36 — ^par  being  5 .  18 —  French  importers  from 
the  United  States  must  pay  10.36  francs  for  goods  valued  at 
5.18  francs,  or,  to  put  it  in  terms  of  American  money,  the 
French  must  pay  $2  for  every  $1  of  goods  purchased  in  the 
United  States.  Contrariwise,  American  purchasers  in  France 
need  pay  but  $1  for  $2  worth  of  goods.  Under  such  conditions 
exports  to  France  are  necessarily  discouraged  and  imports  from 
France  encouraged. 

But  notwithstanding,  the  volume  of  our  exports,  with  some 
notable  variations  in  the  totals,  continued  to  assume  record- 
breaking  proportions,  and  the  average  "favorable  balance  of 
trade  "  was  more  than  $300,000,000  per  month  during  the  year 
1919.  The  dire  need  of  European  countries  for  goods  was  so 
great  that  they  purchased  almost  regardless  of  price.  These 
vast  exports  were  largely  sold  on  credit,  extended  in  part  by 
the  American  government  and  in  part  by  American  banks  and 
exporting  companies.  In  the  meantime  the  European  nations 
could  not  pay  gold  without  still  further  depleting  their  gold 
reserves,  already  quite  inadequate  to  permit  the  redemption  of 
European  currency  in  specie  (see  pp.  270-73),  with  the  result 
that  the  balance  of  indebtedness  to  the  United  States  rapidly 
increased. 


FOREIGN   INVESTMENT  TRUSTS  263 

As  exchange  on  European  countries  steadily  declined,  it 
gradually  became  apparent  that  what  the  experts  had  long 
been  prophesying  was  soon  to  be  a  reality,  namely,  that  our 
foreign  trade  was  to  suffer  a  very  substantial  reduction  in 
volume.  This  realization  finally  led  to  the  passage  by  Congress 
on  December  24,  1919,  of  a  bill  known  as  the  Edge  Act,  which 
authorized  the  establishment  of  a  new  type  of  financial  insti- 
tution for  the  pmpose  of  international  financing,  modeled  after 
the  English  investment  trusts. 

in.    AMERICAN  INVESTMENT  TRUSTS 

As  a  preliminary  to  a  consideration  of  the  new  t)T)e  of 
financial  institution  authorized  by  the  Edge  law,  it  will  be 
of  interest  to  review  very  briefly  our  previous  policy  and  situa- 
tion with  reference  to  foreign  financing.  Prior  to  the  estab- 
lishment of  the  Federal  Reserve  banking  system  in  1913,  most 
of  our  overseas  business  was  financed  by  London  banking 
houses.  The  Federal  Reserve  System  made  it  possible,  as  will 
later  be  shown,  for  American  banks  to  participate  in  the  short- 
time  financing  of  exports.' 

In  the  belief  that  finance  is  an  essential  hand-maiden  to 
trade,  the  Federal  Reserve  Act  also  provided  that  any  national 
bank,  the  capital  and  surplus  of  which  was  in  excess  of 
$1,000,000,  could,  upon  approval  of  the  Federal  Reserve  Board, 
establish  branches  in  foreign  countries  and  dependencies. 
Relatively  little  was  accomplished  in  this  connection,  however, 
for  the  risks  involved  appeared  large,  and  our  banks  had 
abundant  opportunity  to  utilize  their  funds  in  other  ways, 
particularly  after  the  outbreak  of  the  European  war. 

This  Act  was  amended  on  September  17,  1916,  in  order  to 
permit  national  banks  with  a  capital  and  surplus  in  excess  of 
$1,000,000  to  co-operate  in  the  establishment  or  ownership 
of  American  banks  or  corporations,  principally  engaged  in 
foreign  banking,  by  authorizing  the  banks  to  invest  in  the  capital 
stock  of  such  institutions  in  amounts  not  to  exceed  10  per  cent 

I  See  chap.  xx. 


264         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

of  their  capital  and  surplus.  While  some  foreign  financing 
institutions  were  organized  under  this  law,  it  was  felt  that  the 
movement  would  be  greatly  accelerated  if  such  corporations 
were  chartered  by  the  federal  government,  foreign  financing 
being  regarded  as  a  matter  of  national  significance. 

The  next  step  in  the  development  of  overseas  financing  was 
the  passage  of  the  McLean  Act  on  September  17,  1919,  which 
permitted  national  banks,  without  regard  to  size,  to  invest  up 
to  5  per  cent  of  their  capital  and  surplus  in  the  stock  of  corpora- 
tions of  the  kind  contemplated  by  the  Edge  Bill,  then  under 
consideration  by  Congress. 

The  Edge  law  provides  for  the  federal  incorporation  and 
regulation  of  banking  institutions  for  the  purpose  of  engaging 
in  international  or  foreign  banking  or  other  foreign  financial 
operations.  A  capital  stock  of  at  least  $2,000,000  is  required 
for  incorporation. 

The  law  provides  fpr  two  different  classes  of  operations. 
The  first  consists  of  commercial  banking  operations  connected 
with  foreign  trade.  These  institutions  are,  however,  not  per- 
mitted to  compete  with  existing  banks  in  the  field  of  domestic 
commerce.  The  second  type  of  operation  is  investment  in  its 
nature  and  it  is  this  only  that  concerns  us  in  the  present 
chapter. 

The  Edge  Act  permits  the  development  of  investment  trusts. 
The  law  authorizes  these  banking  institutions:  (i)  to  purchase 
and  sell,  with  or  without  their  indorsement  or  guaranty,  securi- 
ties, including  the  obligations  of  the  United  States  or  any  state 
thereof,  but  not  including  shares  of  stock,  except  as  hereafter 
explained;  (2)  to  issue  debentures,  bonds,  and  promissory 
notes  under  such  general  conditions  as  to  security  and  under 
such  limitations  as  the  Federal  Reserve  Board  may  prescribe, 
but  in  no  event  having  liabilities  outstanding  thereon  at  any 
one  time  exceeding  ten  times  the  capital  stock  and  surplus  of 
the  issuing  corporation;  and  (3)  with  the  consent  of  the  Federal 
Reserve  Board  "to  purchase  and  hold  stock  or  other  certificates 
in  any  other  corporation  authorized  under  the  Edge  Act,  or 
under  the  laws  of  any  foreign  country,  colony,  or  dependency, 


FOREIGN  INVESTMENT  TRUSTS  265 

or  of  any  state,  dependency  or  insular  possession  of  the 
United  States,  where  such  corporation  is  not  engaged  in  the 
general  business  of  buying  or  seUing  goods,  wares,  merchandise 
or  commodities  in  the  United  States  and  transacts  only  such 
business  in  the  United  States  as  in  the  judgment  of  the 
Federal  Reserve  Board  is  incidental  to  its  international  or 
foreign  business." 

The  extent  of  such  purchases  without  the  approval  of  the 
Federal  Reserve  Board  is  Umited  to  xo  per  cent  of  its  own  capital 
and  surplus,  except  when  the  investment  is  in  the  shares  of  a 
banking  corporation,  in  which  case  15  per  cent  is  permissible. 

The  idea  of  these  corporations  is  explained  by  Senator 
Edge,  the  author  of  the  bill,  in  the  following  language: 

The  procedure  under  the  prospective  law  is  simplicity  itself; 
it  is  merely  the  application  to  international  trade  of  the  accepted 
method  by  which  Joe  Doe  sells  his  business  to  penniless  Richard  Roe 
and  yet  obtains  actual  cash  payments  in  the  transaction.  The 
American  exporter  ormanufacturer  may  sell  his  goods  to  an  impover- 
ished purchaser — a  foreign  government  or  a  private  concern.  One 
of  the  proposed  corporations  then  may  accept  collateral  from  the 
purchaser,  acceptable  to  the  Federal  Reserv^e  Board,  and  against 
this  issue  debentures  to  sell  to  investors,  and  the  money  so  received 
will  be  paid  to  the  American  seller.  Through  the  powers  granted  to 
these  proposed  corporations  they  may  accept  even  mortgages  on 

the  plants  or  other  real  property  of  the  purchasers Thus  a 

foreign  concern  in  need  of  raw  material  may  obtain  it  by  giving  a 
mortgage  on  its  plant,  and  eventually  by  turning  this  raw  material 
into  finished  product  will  be  able  to  redeem  its  collateral  and  to  put 
aside  a  little  profit  besides. 

The  importance  of  such  institutions  for  the  extending  of 
long-term  credits  to  European  purchasers  is  expressed  by  the 
Guaranty  Trust  Company  of  New  York  as  follows: 

Let  us  suppose,  for  instance,  that  a  corporation  whose  properties 
are  in  the  devastated  section  of  France  desires  to  buy  American 
machinery  to  start  rebuilt  factories  in  operation,  and  that  it  desires  to 
buy  on  credit,  giving  as  security  for  the  purchase  price  only  corporate 
bonds  which  mature  eight  or  ten  years  hence.  Even  though  satisfied 
as  to  the  safety  of  the  security  offered  as  collateral  for  the  extension 


266         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

of  the  credit,  the  American  manufactiirer  is  in  most  cases  tmable 
to  carry  it  until  maturity  because  this  would  tie  up  and  deprive  him 
for  many  years  of  the  use  of  the  capital  which  he  requires  in  his 
business.  Therefore,  the  seller  is  compelled  to  lose  the  sale  unless 
the  bonds  can  be  quickly  converted  into  cash.  It  is  possible  here  to 
relieve  the  situation  by  an  arrangement  made  with  a  coriK>ration 
organized  under  the  Edge  Act  to  take  such  foreign  securities,  advance 
the  cash,  and,  within  such  limitations  as  the  law  and  the  Federal 
Reserve  Board  prescribe,  issue  its  own  notes  which  could  then  be 
offered  to  the  public  for  investment.  By  this  method  the  purchaser 
at  once  receives  the  purchase  price,  and  the  European  buyer  obtains 
the  goods.  The  credit  is  successfully  passed  to  the  American 
investor.' 

The  principle  underlying  this  law  was  applied  during  the 
war  by  the  American  Foreign  Securities  Company  in  making 
possible  a  purchase  by  the  French  government  of  $ioo,ooo,ooc 
worth  of  supplies  from  American  manufacturers. 

On  July  14, 1916,  the  American  Foreign  Securities  Company  was 
incorporated  in  Delaware  by  a  group  of  American  bankers,  to  acquire, 
by  purchase  or  otherwise,  and  to  hold  or  dispose  of  stock,  bonds,  or 
obligations  of  any  foreign  or  domestic  government  or  corpKjration. 
On  July  18,  1916,  the  Company  entered  into  a  contract  with  the 
Government  of  the  French  RepubUc,  whereby  the  Company  made  the 
French  Republic  a  loan  of  one  hundred  million  dollars,  bearing 

interest  from  August  i,  1916,  and  payable  July  31,  1919 

The  Company  not  only  took  the  note  of  the  French  Government 
but  also  insisted  that  the  French  Government  deposit  collateral  with 
the  note.  To  secure  the  payment  of  principal  and  interest  of  the 
loan,  the  French  Republic  pledged  various  securities  with  the  Com- 
pany and  authorized  the  Company  to  rehypothecate  these  securities. 
The  value  of  these  securities  was  calciilated  to  be  one  hundred  and 
twenty  million  dollars,  and  the  French  Government  agreed  to  pledge 
from  time  to  time  additional  securities  so  that  the  calculated  value 
of  the  collateral  should  always  be  20  per  cent  in  excess  of  the 
principal  of  the  loan.  The  collateral  pledge  included  obligations 
of  the  Governments  of  Argentina,  Sweden,  Norway,  Denmark, 
Switzerland,  Holland,  Uruguay,  Egypt,  Brazil,  Spain,  Province  of 
Quebec,   Suez   Canal,   and  various   United   States  and   Canadian 

'  Foreign  Financing  under  the  Edge  Act  (see  n.  i,  p.  259). 


FOREIGN  INVESTMENT  TRUSTS  267 

corporations.  Under  its  authority  to  rehypothecate  these  securities, 
the  Company  deposited  $126,526,534  worth  of  them  with'  "a  financial 
institution"  in  New  York,  as  trustee,  under  a  trust  agreement  to 
secure  $94,500,000  of  the  Company's  three-year  5  per  cent  gold 
notes,  dated  August  i,  1916,  and  payable  August  i,  1919,  which 
notes  the  Company  publicly  offered  for  general  sale  in  July,  191 6, 
at  9§  and  interest.  Throughout  the  war  these  notes  maintained  a 
high  value,  and  on  August  i,  1919,  they  were  paid  in  full.  Mean- 
while the  Company  paid  dividends  averaging  more  than  8  per 
cent  per  annum  upon  its  $10,000,000  of  capital  stock.' 

American  investment  trusts  are  being  formed.  Several 
American  investment  trusts  have  already  been  organized. 
The  first  in  the  field  was  the  Foreign  Bond  and  Share  Corpo- 
ration, organized  under  state  law  in  the  spring  of  1919.  The 
announcement  states : 

The  organizers  include  private  banking  firms  and  some  of  the 
strongest  financial  institutions  throughout  the  United  States.  Among 
them  are  Brown  Brothers  &  Co.,  J.  and  W.  Seligman  &  Co.,  Guaranty 
Trust  Company,  Chase  Securities  Corporation,  Central  Union 
Trust  Company,  Columbia  Trust  Company,  Hayden,  Stone  &  Co., 
all  of  New  York;  First  National  Corporation  of  Boston,  Hibernia 
Bank  and  Trust  Company,  New  Orleans;  First  Trust  and  Savings 
Company,  Cleveland;  Anglo  and  London  Paris  National  Bank, 
San  Francisco;  Mercantile  Trust  Company,  Mississippi  Valley 
Trust  Company,  and  interests  associated  with  the  National  Bank 
of  Commerce,  all  of  St.  Louis;  and  the  Central  Trust  Company  of 
Chicago. 

A  number  of  subscribers  of  the  Foreign  Bond  and  Share  Corpora- 
tion are  now  actively  identified  with  the  Asia  Banking  Corporation, 
Mercantile  Bank  of  the  Americas,  the  American  Foreign  Banking 
Corporation,  Banco  Mercantil  Americano  de  Cuba,  the  China  and 
Japan  Trading  Company,  and  other  American  financial  institutions. 
For  this  reason,  the  new  corporation  is  particularly  well  qualified  to 
develop  American  trade,  to  pass  upon  the  value  and  to  oversee  the 
management  of  enterprises  which  it  finances.* 

■  Gilbert  H.  Montague,  quoted  in  Foreign  Financing  under  the  Edge  Act, 
pp.  11-12.     Published  by  the  Guaranty  Trust  Company  of  New  York. 

'  "America's  First  Investment  Trust  Makes  Its  Appearance,"  National 
Acceptance  Journal,  May,  1919,  p.  35. 


268         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

TTie  second  in  the  field,  apparently,  is  the  Foreign  Finance 
Corporation,  organized  under  the  auspices  of  J.  P.  Morgan  & 
Company,  which  will  confine  its  investments  to  the  issues  of 
private  corporations.  Other  trusts  with  a  capital  varying  from 
$10,000,000  to  $50,000,000,  are  reported  as  now  being  favorably 
considered/ 

Regulation  of  investment  tr lists  appears  to  be  necessary. 
The  need  of  regulation  of  these  investment  trusts  is  pretty 
generally  recognized.  "The  trusts  have  been  praised;  they 
have  also  been  criticized,  denounced,  and  exposed."  But  most 
students  have  concluded  that  they  can  be  very  good  under 
good  management,  while  under  irresponsible  management  they 
ofiFer  opportunity  for  gross  abuse  of  the  investing  public's 
confidence.    The  National  City  Bank  of  New  York  suggests: 

If  we  are  to  have  an  upgrowth  of  "investment 'trusts"  in  this 
country,  it  would  seem  advisable  to  safeguard  the  public  by  some 
protective  legislation  in  advance  of  abuses.  Publicity  in  regard  to 
holdings  has  been  called  for  by  English  critics  as  a  preventive  of 
fraud.  It  might  be  feasible  to  have  "trusts "  write  into  their  charters 
of  incorporation  the  plan  under  which  they  would  operate,  stating 
specifically  whether  they  would  trade  in  securities  for  a  speculative 
profit,  accumulate  straight  investment,  underwrite,  or  promote 
enterprises  or  groups  of  them,  not  forbidding  or  hindering  freedom 
of  activity  in  any  character  of  business,  but  providing  for  publicity 
and  the  protection  of  investors  against  the  perversion  of  their  funds 
out  of  the  use  to  which  they  have  consented.  Holding  companies 
or  control  schemes  might  be  forbidden,  and  mergers  of  "trusts" 
permitted  only  under  safeguards  designed  to  protect  against  dilutiot 
of  valuable  holdings  with  worthless  securities.  "  Founders'  shares  " 
are  designed  as  a  substitute  for  commissions  on  the  investment 
business  handled  by  managements  for  "trusts,"  the  commission 
thus  paid  being  a  permanent  share  in  income  instead  of  a  certain 
per  cent  of  the  principal.  Our  law  might  well  limit  the  share  of 
"founders'  shares"  in  the  income  of  "trusts"  to  a  moderate  per- 
centage of,  say,  5  per  cent.  The  possibilities  of  abuse  of  "invest- 
ment trusts"  are  so  easy  that  a  very  carefid  study  of  legislation 
designed  to  protect  investors  without  hampering  honest  management 

*  Date  of  February,  1920. 


FOREIGN  INVESTMENT  TRUSTS  269 

should  be  made  before  any  considerable  development  in  this  kind  of 
financial  institution  gets  under  way.  The  "trust"  has  the  faults  of 
its  virtues.  Its  success  depends  entirely  upon  the  free  skill  and  judg- 
ment of  the  men  who  manage  its  investments.  A  certain  measure 
of  supervision  and  requirement  of  publicity  may  not  hurt,  but  the 
plan  is  ineffective  if  the  discretion  of  managers  is  limited  by  such 
rules  as  govern  savings  banks  and  insurance  companies.  The  free- 
dom of  action  that  managers  must  have  is  a  constant  temptation, 
as  the  history  of  some  English  "trusts"  has  demonstrated,  for  them 
to  use  the  investors'  money  in  schemes  of  their  own,  or  for  "wildcat " 
financiers  to  perpetrate  actual  fraud,  and  it  is  very  difficult  to  prove 
fraud  even  in  flagrant  instances  of  it.  But  in  the  hands  of  men  or  of 
companies  of  known  responsibility  and  ability,  the  "investment 
trust"  can  be  made  a  powerful  machine  for  comprehensive  enter- 
prises abroad. 

IV.    FUTURE  OF  AMERICAN  FOREIGN 
^  INVESTMENTS 

There  is  a  very  real  doubt,  however,  whether  the  growth  of 
American  investment  trusts  will  be  rapid  and  whether  the 
volume  of  our  foreign  investments  will  show  a  notable  expansion 
in  the  next  few  years.  In  opposition  to  the  view  presented 
above  with  reference  to  the  need  of  extending  vast  credits'  to 
Europe,  a  contrary  opinion  may  be  advanced,  one  that  is  held 
by  many  prominent  financiers  and  economists,  both  in  the 
United  States  and  abroad. 

It  is  pointed  out  that  the  economic  relations  between  the 
United  States  and  Europe  are  very  different  from  those  that 
existed  during  the  years  of  our  greatest  absorption  of  European 
capital.  In  the  first  place,  the  United  States  was  in  a  position 
to  export  large  quantities  of  foodstuffs  and  raw  materials — 
paying  therewith  the  interest  on  accumulated  European 
investments  here  and  preventing  thereby  a  depreciation  of 
American  exchange.  At  the  present  time,  Europe  cannot 
well  offset  by  exports  to  us  the  amount  of  the  annual  interest 
due  us,  roughly  $600,000,000.  Nearly  all  students  agree  that 
interest  payments  must  be  postponed  for  many  years,  if  not 
indefinitely,  if  the  exchanges  are  to  be  brought  back  to  an 


27©         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

equilibrium.  So  long  as  this  huge  interest  charge  enters  into 
the  balance  against  Europe,  exchange  rates  must  remain 
unbalanced.  Moreover,  an  extension  of  additional  credits 
to  the  European  countries  obviously  serves  to  place  them  under 
an  ever-growing  burden  of  indebtedness  and  thus  only  delays 
and  makes  more  difficult  the  task  of  ultimate  readjustment. 

In  the  second  place,  the  European  monetary  systems  are 
very  seriously  deranged,  redemption  of  paper  currency  in 
gold  having  been  suspended  early  in  the  war.  In  most  of  the 
continental  countries,  indeed,  the  depreciation  of  paper  money 
is  quite  as  notorious  as  in  any  of  the  striking  historical  examples 
of  flat  currency.  In  Germany,  for  instance,  the  gold  reserve  in 
the  central  bank,  in  which  is  impounded  practically  the  entire 
national  supply,  is  now  less  than  2  per  cent,  as  against  over 
70  per  cent,  normally,  before  the  war;  and  the  situation  is 
steadily  growing  worse.^  Under  such  circumstances  it  is 
impossible  for  Europe  to  allow  any  considerable  export  of  specie, 
the  means  normally  relied  upon  to  correct  trade  and  financial 
maladjustments,  for  the  European  monetary  systems  would  be 
completely  demoralized  in  a  few  weeks'  time  if  the  present 
scanty  gold  reserves  were  much  further  depleted. 

•  It  is  important  to  bear  in  mind  in  this  connection  that  while 
an  excess  of  American  exports  over  imports  is  a  factor  in  the 
present  depreciation  of  the  exchanges  (see  chap,  viii),  the  depre- 
ciated European  currencies  are  themselves  very  imp)ortant 
factors  in  the  situation;  for  we  are  no  longer  comparing  Ameri- 
can gold  dollars  with  gold  pounds,  francs,  marks,  etc.;  we  are 
comparing  them  with  depreciated  paper  pounds,  francs,  and 
marks. 

The  chart  on  the  following  page  indicates  the  great  shift- 
ing of  the  world's  gold  supplies  that  occurred  during  the 
war,  as  a  result  of  the  dire  needs  of  the  European  belligerents  for 
supplies.  If  Europe's  depleted  gold  resources  should  be 
further  reduced  by  gold  exports,  the  vast  amount  of  paper 
currency  outstanding  in   Europe  would  be  depreciated  still 

'  August,  1920. 


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272         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

further  than  at  present,  with  a  resulting  disastrous  effect  upon 
the  exchange  rates.  It  is  accordingly  urged  that  the  only 
means  whereby  any  of  these  countries  with  depleted  exchanges 
can  hope  to  rectify  trade  balances  and  restore  the  gold  standard 
is  by  immediately  bending  every  energy  toward  increasing 
exports  and  decreasing  imports  as  much  and  as  rapidly  as 
possible.  Reduced  consumption,  the  elimination  of  all  non- 
essential activities,  and  unremitting  work  are  regarded  as  the 
only  means  to  economic  salvation. 

It  should  be  noted  that  the  twelve  billion  dollars  that 
Europe  now  owes  to  the  United  States  involves  an  annual  inter- 
est charge,  to  be  met  by  the  export  of  goods,  of  nearly  six 
hundred  million  dollars,^  making  no  allowance  for  the  repay- 
ment of  the  principal  of  the  indebtedness,  before  an  inflow  of 
gold  to  Europe  can  be  secured.  It  may  be  observed  also  that 
in  the  case  of  Germany,  since  indemnity  payments  must  take 
the  form  of  exports,  the  excess  of  exports  over  imports  must 
be  greater  than  the  amount  of  the  indemnity  payments  to  the 
allied  countries  before  an  influx  of  gold  will  be  possible. 

A  study  of  the  accompanying  chart,  showing  the  redistribu- 
tion of  the  world's  gold  supply  during  the  war,  will  help  to 
visualize  the  problem  of  international  economic  readjustment. 
There  cannot  be  a  restoration  of  normal  international  com- 
mercial and  financial  operations  until  the  world's  gold  supply  is 
in  considerable  measure  redistributed  among  the  commercial 
nations  of  the  earth  and  until  trade  and  financial  relations  are 
restored  substantially  to  the  pre-war  basis.  This  will  doubt- 
less require  many  years  to  accomplish;  and  it  is  certain  to 
involve  many  grave  problems  of  adjustment,  not  the  least  of 
which  is  the  effect  of  a  large  outflow  of  gold  upon  the  reserves  of 
American  banking  institutions,  upon  the  level  of  prices  in  the 
United  States,  and  in  consequence  of  both  of  these  factors  upon 
American  industrial  activity.  Further  consideration  of  this 
question  is  to  be  found  in  chapter  xxvi  below. 

'  This  is  assuming  we  insist  on  interest  payments.  The  student  should 
also  bear  in  mind  that  there  are  other  than  trade  factors  which  figure  in 
the  international  scalepans.    Refer  back  to  chap.  viii. 


FOREIGN  INVESTMENT  TRUSTS  273 

In  the  third  place,  it  is  also  pointed  out  by  many  students 
that  a  stage  has  now  been  reached  when,  even  if  it  were  wise  to 
make  large  loans  to  Europe,  the  risks  involved  have  become 
virtually  prohibitive.  The  great  depreciation  of  the  foreign 
exchanges,  the  increasing  depreciation  of  continental  paper 
money,  the  disruption  of  the  general  European  economic  organi- 
zation, with  fundamental  industries  such  as  transportation  and 
public  utilities  in  a  deplorable  condition,  taken  in  conjunction 
with  the  widespread  industrial  and  political  unrest,  make  it 
highly  improbable  that  American  investors  would  now  be 
willing  to  assume  the  risks  involved  in  large  European  loans, 
particularly  in  view  of  the  preferred  investment  opportunities 
at  home.  The  longer  the  delay  in.  providing  machinery  for 
the  extension  of  foreign  credits,  the  weaker  has  become  the 
European  credit  position. 

Finally,  it  is  urged  that  the  American  financial  and  industrial 
situation  is  now  such  that  it  would  be  undesirable,  if  not  impos- 
sible, from  the  American  standpoint  to  make  large  credit 
extensions  to  Europe.  Mainly  as  a  result  of  the  rapid  rise  of 
prices  in  this  country,  the  supplies  of  available  funds  are  now 
inadequate  to  provide  for  European  needs  and  at  the  same 
time  to  meet  our  own  financial  requirements  in  connection 
with  raising  new  capital  for  raUroad,  public  utility,  housing, 
and  other  construction  activities.  There  is  a  notable  scarcity 
of  capital  for  the  needs  of  business.'  Readjustments  that 
appear  to  be  in  store  for  us  may  in  the  course  of  a  year  or  so 
conceivably  alter  this  situation;  but  for  the  present  it  is  believed 
that  we  are  virtually  estopped  from  any  large  participation  in 
overseas  loans. 

In  this  chapter  we  have  been  considering  certain  of  the 
international  aspects  of  the  financial  organization  of  society. 
What  now  is  to  be  said  by  way  of  conclusion  as  to  the  efficiency 
with  which  the  international  financial  system  performs  its 
part  in  promoting  the  economic  development  of  the  world  ? 

'  This  is  mainly  reflected  in  very  low  bank  reserves.     See  chap.  xxv. 


274         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

What  of  its  adaptability  to  the  varying  requirements  of  the 
international  economic  organization  ? 

We  have  seen  how  the  system  of  credit,  assisted  by  invest- 
ment trusts  and  the  stock  exchange,  has  enabled  the  people  of 
England,  for  example,  to  utilize  their  capital  resources  in 
promoting  the  economic  development  of  the  remote  and  back- 
ward regions  of  the  earth,  thus  enlarging  the  field  within  which 
economic  specialization  may  be  carried  out  and  increasing 
thereby  the  volume  of  wealth  production  throughout  the 
world.  There  would  seem  to  be  Uttle  doubt  that  so  far  as 
purely  economic  considerations  are  concerned  this  "financial 
exploitation"  has  been  distinctly  advantageous. 

We  have  also  found,  however,  that  the  economic  rehabili- 
tation of  the  world  following  the  Great  War  presents  a  problem 
of  extraordinary  difficulty;  and  some  of  this  difficulty,  it  would 
seem,  may  fairly  be  attributed  to  the  financial  system  itself. 
The  very  fact  that  international  trade  is  dependent  upon  the 
international  exchanges  renders  it  practically  impossible  for  the 
world  to  do  in  this  time  of  acute  economic  crisis  what  most 
needs  to  be  done.  Depreciated  exchanges,  as  we  have  seen, 
render  the  cost  of  imported  goods  virtually  prohibitive  to  those 
coimtries  which  stand  in  greatest  need  of  imports.  And 
depreciated  exchanges,  it  should  be  recalled,  reflect  not  only  a 
present  excess  of  imports  over  exports;  even  more  they  reflect 
accumulations  of  past  indebtedness  and  the  depreciated  cur- 
rencies of  the  various  European  countries.  Should  Europe 
be  forced  to  undergo,  perhaps,  a  generation  or  more  of  near 
chaos — economic  and  social — merely  because  the  depreciated 
exchanges  left  as  a  legacy  of  the  war  make  it  practically  impos- 
sible, financially  speaking,  for  the  United  States  and  other 
little  afflicted  countries  to  furnish  the  materials  required  for 
European  reconstruction  ?  From  the  viewpoint  of  enlightened 
self-interest  the  rest  of  the  world  cannot  afford  to  take  the  stand 
that  Europe  must  pay  the  piper;  for  because  of  the  inter- 
dependence of  nations  under  the  world-economic  organization 
of  the  present,  the  economic  collapse  of  Europe  could  not 
fail  to  produce  very  serious  economic  consequences  throughout 


FOREIGN  INVESTMENT  TRUSTS  275 

the  world ;  it  is  clearly  to  the  interest  of  the  rest  of  the  world 
almost  as  much  as  to  that  of  Europe  that  Europe  be  placed  on 
her  feet,  economically  speaking,  at  a  very  early  moment.  But 
unfortunately  the  state  of  the  exchanges  renders  this  consum- 
mation virtually  impossible  of  achievement. 

It  is  not  without  significance  in  this  connection  that  numer- 
ous efforts  have  been  made  since  the  war  to  circumvent  the 
financial  barrier  to  international  trade  that  is  imposed  by  the 
depreciated  exchanges  through  a  resort  to  a  species  of  inter- 
national barter.  In  order  to  enable  German  manufacturers 
to  procure  raw  materials  certain  Dutch  concerns,  for  example, 
have  shipped  raw  materials  to  Germany  under  an  agreement 
that  the  German  manufacturers  will  subsequently  pay  for 
the  materials  by  reshipping  to  Holland  a  specified  amount  of 
finished  product.  Some  of  the  international  financing  cor- 
porations recently  organized  in  the  United  States  hope  to 
stimulate  American  export  trade  and  the  economic  recovery 
of  Europe  by  supplying  materials — particularly  to  Germany, 
Austria,  and  the  Balkan  states — which  are  there  to  be  worked 
up  into  finished  products  and  sold  under  the  supervision  of 
American  financial  interests.  There  are  obviously  some  very 
interesting  political  problems  relating  to  the  economic  control 
involved  in  this  method  of  restoring  European  economic  life. 
It  remains  to  be  seen,  however,  to  what  extent  either  of  these 
interesting  and  suggestive  devices  will  prove  a  practicable 
substitute  for  the  ordinary  financial  method  of  conducting 
international  business. 

As  a  means  of  lessening  the  depreciation  of  the  exchanges 
and  facilitating  thereby  the  importation  of  the  materials 
required  for  European  reconstruction,  the  cancellation  of 
allied  indebtedness  to  the  United  States  and  of  the  German 
indebtedness  to  the  allies  has  been  urged  by  numerous  students. 
But  the  utter  lack  of  understanding  on  the  part  of  even  ordi- 
narily well-informed  people  of  the  fundamental  principles 
involved  makes  such  a  suggestion  seem  absurd,  if  not  criminal. 
Shall  those  who  brought  on  the  war  be  permitted  to  escape 
the  financial  penalties  they  so  richly  deserve!    And  shall  the 


276         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

United  States  donate  twelve  billions  of  dollars  to  our  former 
allies,  who  are  even  now  perfecting  their  plans  to  undersell  us 
in  all  the  markets  of  the  world,  including  our  own!  It  is  too 
much  to  expect  the  "unseen  forces"  which  we  have  been 
discussing  to  stand  in  the  balance  against  such  apparently 
conclusive  considerations  as  are  suggested  in  these  current 
exclamations.  The  pecuniary  system  here  again  tends  to 
obscure  the  underlying  economic  factors  which  alone  are 
important. 

But  even  if  indemnities  were  foregone  and  international 
debts  canceled,  the  exchanges  would  still  not  be  completely 
restored  to  par  for  the  reason  that  the  depreciated  currencies 
of  Europe  would  not  thereby  be  corrected;  hence  a  purely 
financial  barrier  would  still  serve  to  impede  the  process  of 
world-economic  recovery.  So  long  as  nations  organize  their 
economic  activities  on  the  basis  of  currency  systems  the  founda- 
tion of  which  is  the  gold  standard,  disruptions  of  these  currency 
systems  will  inevitably  entail  very  serious  economic  conse- 
quences and  render  peculiarly  difficult  the  conduct  of  inter- 
national commercial  operations. 

All  this  is  not  to  argue,  however,  that  the  financial  system 
should  necessarily  be  abandoned.  For  we  must  always  reckon 
with  alternatives;  and  notwithstanding  its  apparent  short- 
comings under  conditions  such  as  we  have  been  discussing,  it 
may  still  be  found  that  all  things  considered  the  financial 
mechanism  is  superior  to  any  other  that  could  be  suggested. 
It  is,  however,  not  a  part  of  our  present  task  to  speculate  upon 
this  interesting  subject.  We  must  remain  content  with  the 
portrayal  of  the  actual  working  of  the  system  of  international 
finance  in  the  world  as  it  is  now  organized,  with  pointing  out 
its  shortcomings  as  well  as  its  elements  of  strength  in  perform- 
ing the  tasks  assigned  to  it. 


FOREIGN  INVESTMENT  TRUSTS  277 

QUESTIONS  FOR  DISCUSSION 

1.  How  do  you  accoxmt  for  the  pre-eminence  of  Great  Britain  in  the 
field  of  foreign  investment  ? 

2.  Indicate  the  economic  consequences  of  British  foreign  invest- 
ments to  (fl)  Great  Britain,  (b)  to  the  countries  in  which  the 
investments  were  placed. 

3.  State  the  essential  principle  of  the  investment  trust. 

4.  Does  the  investment  trust  always  sell  its  own  obligations  to  an 
investing  public  ? 

5.  What  is  the  security  of  an  individual  who  invests  in  foreign 
securities  through  the  intermediation  of  an  investment  trust  ? 

6.  Enumerate  the  factors  which  led  to  a  shift  in  America's  financial 
position  during  the  war  from  a  debtor  to  a  creditor  nation. 

7.  Review  the  last  part  of  chapter  viii  on  the  efifect  of  the  war  on 
the  European  exchanges  and  then  summarize  the  causes  of  the 
present  depreciation  of  foreign  exchange. 

8.  Look  up  the  present  exchange  rates  on  the  leading  European 
countries.  Compute  the  effect  in  each  case  on  the  cost  of 
imported  goods. 

9.  Just  how  would  the  development  of  American  investment  trusts 
affect  exchange  rates  ? 

10.  State  the  important  principles  of  the  Edge  law. 

11.  Describe  concretely  what  security  you  would  have  in  purchasing 
one  of  the  bonds  of  an  institution  organized  under  the  Edge  law. 

12.  What  regulation  and  supervision  do  you  think  is  needed  for  the 
control  of  investment  trusts  ? 

13.  Two  schools  of  thought  have  developed  in  connection  with  the 
relationship  of  America  to  European  reconstruction:  one  holds 
that  vast  loans  must  be  made  by  the  United  States  to  Europe ; 
the  other  that  the  only  remedy  for  the  situation  is  European 
thrift,  hard  work,  and  the  early  development  of  favorable  trade 
balances  for  the  European  belligerents.  With  which  do  you 
agree  ? 

14.  "To  grant  large  loans  would  be  an  unwise  and  uncharitable 
policy  for  all  parties  concerned,  because  it  would  push  nearer  the 
precipice  both  debtor  and  creditor  country  instead  of  leading 
them  in  the  opposite  direction  toward  gradual  recuperation." 
Discuss. 


278         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

15.  "Europe  cannot  greatly  increase  exports  without  large  imports 
of  raw  materials,  and  prices  of  raw  materials  are  prohibitive  in 
view  of  present  exchange  rates."  What  would  be  your  way 
out  of  the  dilemma  ? 

16.  What  eflFect  would  the  cancellation  of  indemnities  and  inter- 
national debts  have  upon  exchange  rates?  Would  you  favor 
such  cancellation  ? 

17.  "For  the  vast  number  of  American  consumers,  a  recession  of 
prices  is  of  infinitely  greater  importance  than  boosted  exports  sold 
at  high  prices  to  purchasers  whose  natural  limit  of  credit  has  been 
fairly  exhausted."    Discuss. 

18.  What  conclusion  do  you  draw  from  a  study  of  the  chart  on  page 
271  showing  the  shift  in  the  world's  gold  supply  during  the  war  ? 

19.  Do  you  conclude  that  the  emergence  of  the  United  States  as  a 
creditor  nation  is  an  unmitigated  good  fortune? 

REFERENCES  FOR  FURTHER  READING 

America's  Opportunity.  A  booklet  published  by  the  Mechanics 
and  Metals  National  Bank,  New  York. 

Foreign  Financing  under  the  Edge  Act.  A  pamphlet  published 
by  the  Guaranty  Trust  Company  of  New  York. 

Kahn,  Otto  H.:  Impressions  from  a  Journey  in  Europe.  A 
pamphlet  distributed  by  the  Committee  of  American  Business  Men, 
47  West  34th  St.,  New  York. 

Keynes,  J.  M.:  The  Economic  Consequences  of  the  Peace,  chaps, 
v-vii. 

Vanderlip,  Frank  A.:  What  Happened  to  Europe? 

Warburg,  Paul  M. :  "Europe  at  the  Crossroads,"  Political  Science 
Quarterly,  December,  1920. 

Boss,  John  F.  and  Moulton,  Harold  G:  America  and  the  Balance 
Sheet  of  Europe,  chap,  xix 


CHAPTER  XVI 

THE  STOCK  EXCHANGE  AND  CAPITAI. 
RAISING 

In  the  chart  on  page  136  showing  the  financial  institutions 
associated  with  the  raising  of  capital  under  modern  conditions, 
the  stock  exchange  was  placed  at  one  side  and  designated  "a 
great  central  market  place."  The  reason  for  this,  as  already 
indicated,  is  that  the  exchange  is  not  a  direct  intermediary 
between  the  borrowing  corporation  and  the  lender  of  funds,  its 
services  being  rather  of  an  indirect  nature.  We  shall  find, 
however,  that  the  stock  exchange  is  of  vital  importance  to 
practically  all  of  the  institutions  that  make  up  the  financial 
structure  of  society. 

In  considering  the  importance  of  the  stock  exchange  from 
the  point  of  view  of  capital  raising,  it  will  not  be  pertinent  to 
enter  upon  a  discussion  of  the  evils  of  speculation,  manipulation, 
"wash  sales,"  the  ethics  of  future  trading,  the  system  of  "puts 
and  calls,"  etc.  The  purpose  here  is  merely  to  reveal  the 
part  that  the  stock  exchange  actually  plays  in  connection  with 
the  process  of  capital  raising. 

I.    HISTORY  OF  STOCK  EXCHANGES 

The  rise  of  stock  exchanges  is  directly  associated  with  the 
development  of  the  corporation  as  a  capital-raising  device. 
From  the  moment  shares  of  stock  were  issued  by  corporations, 
trading  in  them  by  both  investors  and  speculators  began.  "  No 
sooner  were  there  bits  of  paper  to  deal  in  than  jobbers  or  brokers 
sprang  up  to  handle  them,  and  by  natural  gregarious  processes 
these  dealers  gathered  in  one  spot."  The  nature  of  the  earliest 
stock  speculation  in  England  is  described  in  the  quotation  from 
Bagehot  given  on  pages  144-46  above.  Twenty  years  later 
there  developed  a  great  speculative  mama,  which  culminated  in 


28o         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  South  Sea  Bubble  of  171 7.  In  this  early  speculation  jobbers 
and  brokers  first  congregated  on  the  rotunda  of  the  Bank  of 
England  and  at  the  Royal  Exchange,  which  had  been  estab- 
lished for  the  purpose  of  exchanging  abraised  and  clipped, 
foreign  and  domestic  coins.  Later,  as  the  business  expanded, 
neighboring  streets  an  J  coffee  houses  were  utilized,  and 
Exchange  Alley,  Old  Jonathan's  Coffee  House,  Corn  Hill, 
Lombard  Street,  and  Sweeting's  Alley  became  the  centers  of 
activity.  When  Old  Jonathan's  burned  down  in  1748,  New 
Jonathan's,  located  in  Threadneedle  Street,  succeeded  it. 
By  common  consent  of  the  brokers  who  traded  there.  New 
Jonathan's  was  converted  in  1773  into  The  Stock  Exchange, 
which  was  "wrote  over  the  door." 

The  New  York  Stock  Exchange,  as  at  present  organized,  is 
the  result  of  more  than  a  century  of  evolution.  The  first 
organization  of  stock  brokers  in  the  metropolis  dates  from 
1792,  though  it  was  not  until  181 7  that  the  organization  assumed 
a  very  definite  form.  The  rules  and  regulations  governing  its 
operations  have  been  modified  and  extended  from  time  to  time 
to  meet  the  changing  requirements  of  a  rapidly  expanding 
industrial  and  financial  system. 

The  New  York  Curb,  or  outside  market,  really  antedates 
the  New  York  Stock  Exchange,  the  latter  indeed  having  been 
an  outgrowth  of  street  trading  in  the  eighteenth  century.  Long 
before  the  organization  of  the  Stock  Exchange  in  1792,  a  group 
of  brokers  was  accustomed  to  congregate  daily  around  a  tree  in 
the  old-time  financial  district  of  New  York  and  there  execute 
orders  for  customers.  The  incorporation  of  these  brokers  into 
a  formal  organization  did  away  for  a  time  with  outside  trad- 
ing; but  under  varying  conditions  and  more  or  less  continu- 
ously there  has  been  curb  trading  throughout  the  nineteenth 
century.  It  was  not,  however,  until  the  great  development  in 
stock  operations,  brought  about  by  the  great  era  of  corporate 
development  and  financial  consolidation  beginning  about  1898, 
that  the  Curb  market  became  of  real  importance.  It  now 
affords  a  public  market  place  where  persons  can  buy  and  sell 
securities  which  are  not  listed  o^  any  organized  exchange. 


THE  STOCK  EXCHANGE  AND  CAPITAL  RAISING       281 

The  Consolidated  Stock  Exchange  was  organized  in  1875 
for  trading  in  mining  securities;  but  it  altered  its  name,  as  well  as 
the  scope  of  its  business,  in  1886.  At  the  present  time  by  far 
the  greater  part  of  the  trading  on  the  consolidated  exchange 
is  in  securities  that  are  listed  upon  the  New  York  Stock 
Exchange.  The  Consolidated  also  deals  in  shares,  however, 
that  are  not  listed  on  the  main  exchange,  as  well  as  in  certain 
mining  securities  that  are  excluded  therefrom.  It  further 
differs  from  the  big  exchange  in  that  it  makes  a  specialty  of 
broken  lots,  that  is,  transactions  in  less  than  one  hundred 
share  units,  which  is  the  minimum  on  the  regular  exchange. 

The  average  annual  sales  of  shares  of  stock  on  the  New  York 
Stock  Exchange  in  the  decade  1 899-1 909  was  196,500,000,  at 
prices  which  involved  an  annual  average  turnover  of  $15,500,- 
000,000.  During  this  same  decade  bond  transactions  averaged 
about  $800,000,000  a  year.  This  is  at  the  rate  of  about  650,000 
shares  per  day  of  a  par  value  of  $100  for  stock,  and  about  260,000 
one-hundred-dollar  bonds.  During  the  great  stock  market 
activity  of  the  svmimer  of  191 9,  as  high  as  2,000,000  shares 
were  traded  in  a  day,  while  for  many  weeks  the  daily  sales  never 
were  less  than  a  million  shares.  Curb  transactions  were  roughly 
as  follows  for  the  year  1908:  bonds  $66,000,000;  stocks,  of  which 
90  per  cent  were  industrials,  $46,595,000.  The  sales  on  the 
Consolidated  Exchange  average  around  50,000,000  shares  per 
annum. 

n.    THE  ORGANIZATION  OF  EXCHANGES 

The  New  York  Stock  Exchange  is  a  voluntary  association, 
limited  to  1,100  members,  of  whom  about  700  are  active. 
Of  the  remainder,  some  are  residents  of  other  cities.  Member- 
ships on  the  Exchange  have  usually  been  sold  for  about  $80,000, 
though  a  record  of  more  than  $100,000  was  recently  established. 
Numerous  prominent  capitalists  hold  memberships  merely  for 
the  purpose  of  availing  themselves  of  the  reduced  commission 
charges  which  the  rules  authorize  between  members.  The 
Exchange  as  such  does  no  business;  it  merely  provides  faciUties 
to  members,  and  regulates  their  conduct,  insuring  that  all 


282         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

transactions  are  conducted  in  accordance  with  the  highest 
standards  of  business  integrity.  The  governing  power  is  an 
elective  committee  of  40  members. 

The  patrons  of  the  Exchange  have  been  divided  into  the 
following  groups: 

1.  Investors,  who  personally  examine  the  facts  relating  to 
the  value  of  securities  or  act  on  the  advice  of  reputable  and 
experienced  financiers  and  pay  in  full  for  what  they  buy. 

2.  Manipulators,  whose  connection  with  corporations  issu- 
ing or  controlling  particular  securities  enables  them  under 
certain  circumstances  to  move  the  prices  up  or  down,  and  who 
are  thus  in  some  degree  protected  from  dangers  encountered  by 
other  speculators. 

3.  Floor  traders,  who  keenly  study  the  markets  and  the 
general  conditions  of  business  and  acquire  early  information 
concerning  the  changes  which  affect  the  value  of  securities. 
From  their  familiarity  with  the  technique  of  dealings  on  the 
exchange  and  ability  to  act  in  concert  with  others  and  thus 
manipulate  values,  they  are  supposed  to  have  special  advan- 
tages over  other  traders. 

4.  Outside  operators  having  capital,  experience,  and  knowl- 
edge of  the  general  conditions  of  business.  Testimony  is  clear 
as  to  the  result  which  in  the  long  run  attends  their  operations. 
Commissions  and  interest  charges  constitute  a  factor  always 
working  against  them.  Since  good  luck  and  bad  alternate  in 
time,  the  gains  only  stimulate  these  men  to  larger  ventures,  and 
they  persist  in  them  till  a  serious  or  ruinous  loss  forces  them 
out  of  the  "Street." 

5.  Inexperienced  persons,  who  act  on  interested  advice, 
"  tips,"  advertisements  in  newspapers,  or  circulars  sent  by  mail, 
or  "take  flyers"  in  absolute  ignorance  and  with  blind  confi- 
dence in  their  luck.  Almost  without  exception  they  eventually 
lose.V 

The  "listing^'  of  securities  is  a  safeguard  against  fraud 
and  irregtdarities.     Before  securities  can  be  traded  in  on  the 

*  From  report  of  Governor  Hughes's  Committee  on  Speculation  in 
Securities  and  Commodities  (1909),  Money  Trust  Investigation,  pp.  2186-87. 


THE  STOCK  EXCHANGE  AND  CAPITAL  RAISING       283 

exchange  they  must  be  listed  by  a  committee  of  the  Stock 
exchange  which  passes  on  applications.  The  Hughes  Com- 
mittee on  Speculation  states  the  importance  of  listing  in  the 
following  language: 

While  the  Exchange  does  not  guarantee  the  character  of  any 
securities,  or  affirm  that  the  statements  filed  by  the  promoters  are 
true,  it  certifies  that  due  diligency  and  caution  have  been  used  by 
experienced  men  in  examining  them.  Admission  to  the  list  therefore 
established  a  presumption  in  favor  of  the  soundness  of  the  securities 
so  admitted.  And  securities  authorized  to  be  bought  and  sold  on 
the  Exchange  which  have  not  been  subjected  to  such  scrutiny  are 
said  to  be  in  the  unlisted  department,  and  traders  who  deal  in 
them  do  so  at  their  own  risk.' 

The  "Committee  on  Stock  Lists"  lays  down  detailed 
requirements  with  reference  to  the  engraving  and  printing  of 
bonds  and  shares,  the  form  in  which  these  securities  shall  be 
made  out,  and  the  specific  information  that  must  be  recited 
on  the  securities,  the  purpose  being  to  prevent  the  counter- 
feiting of  securities.  The  application  for  listing  must  be 
accompanied  in  the  case  of  stocks  by  the  following  and  other 
papers:  copies  of  the  charter  of  incorporation;  by-laws;  leases 
and  special  agreements;  copy  of  resolutions  of  stockholders 
authorizing  issue;  certificate  of  proper  public  authority  for 
issue;  opinion  of  independent  coimsel  as  to  legality  of  (o)  organi- 
zation, (b)  authorization,  (c)  issue,  {d)  validity  of  the  securities; 
detailed  distribution  of  securities;  certificate  of  registrar 
showing  amount  of  securities  registered;  report  of  a  qualified 
engineer  covering  actual  physical  condition  of  property;  map  of 
property;  contemplated  expansion;  specimens  of  all  securities 
to  be  listed.  The  requirements  with  reference  to  bonds  are 
even  more  detailed,  owing  to  the  many  different  kinds  of 
mortgage  liens  and  the  rights  of  bondholders  thereunder. 
The  cost  of  listing  is  $50  for  each  one  million  dollars  or  fraction 
of  the  par  value  of  securities.  With  securities  of  no  par  value, 
it  is  $50  for  each  ten  thousand  shares, 

^Ibid.,  p.  2190. 


284         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

A  corporation  whose  shares  are  listed  on  the  exchange 
must  agree  to  publish  and  submit  an  annual  report  to  its 
stockholders  at  least  fifteen  days  before  its  annual  meeting, 
showing  an  income  account  and  balance  sheet  of  itself  and 
of  constituent  and  subsidiary  conpanies  which  it  owns  or  con- 
trols. The  report  must  also  contain  a  statement  of  the  physi- 
cal condition  of  the  corporate  properties  at  the  time. 

The  Consolidated  Exchange  has  a  membership  of  1,527, 
about  450  of  whom  are  active.  Methods  of  conducting  business 
here  are  very  similar  to  those  at  the  stock  exchange.  It  is  of 
note  that  strained  relations  have  existed  between  the  two 
exchanges  since  the  lesser  one  undertook  in  1886  to*  deal  in 
other  than  mining  shares.  In  cases  where  the  Consolidated 
Exchange  permits  dealing  in  shares  which  are  not  listed  on  the 
Stock  Exchange,  as  noted  above,  it  prescribes  a  form  of  listing 
requirements.  It  appears,  however,  that  securities  are  seldom 
listed  before  actual  trading  in  them  has  begun. 

The  Curb  markeP  is  an  important  auxiliary  institution.  The 
New  York  Curb  market  is  held  in  the  open  air  and  now  occupies 
a  section  of  Broad  Street,  where  an  inclosure  is  made  in  the 
center  of  the  road  by  means  of  a  rope,  within  which  the  traders 
are  supposed  to  confine  themselves,  leaving  space  on  each 
side  for  street  traffic.  During  the  period  of  active  trading, 
however,  the  crowd  often  extends  from  curb  to  curb.  There  are 
about  200  subscribers,  of  whom  about  150  appear  on  the  Curb 
each  day,  together  with  about  an  equal  number  of  messenger 
boys  and  clerks.  Many  of  the  members  of  the  Curb  are  also 
members  of  the  New  York  Stock  Exchange,  and  a  large  pro- 
portion of  its  business — about  85  per  cent — comes  through  the 
offices  of  members  of  the  New  York  Stock  Exchange.  The 
reason  why  this  trading  remains  on  the  street  is,  interestingly 
enough,  that  the  constitution  of  the  New  York  Stock  Exchange 
prohibits  its  members  from  engaging  in  any  transaction  in  any 
other  authorized  stock  exchange  in  New  York.  If  the  Curb 
were  put  under  a  roof  and  definitely  organized  as  an  exchange, 
the  bulk  of  its  trading  could  not  be  maintained  without  a 
revision  of  the  constitution  of  the  Stock  Exchange. 

» In  192 1  the  curb  market  was  moved  indoors. 


THE  STOCK  EXCHANGE  AND  CAPITAL  RAISING       285 

The  services  performed  by  the  Curb  have  been  stated  as 
follows:* 

"First,  it  is  the  market  place  for  the  issued"  of  many  of  the 
industrial,  mining,  and  miscellaneous  enterprises  that  are  con- 
stantly being  created. 

"Second,  it  provides  a  ready  market  for  the  securities  of 
small  concerns  whose  capitalization  may  be  of  relatively 
moderate  size.  With  par  values  ranging  from  ten  cents  to 
twenty-five  dollars,  a  satisfactory  market  for  these  securities 
would  be  impossible  but  for  the  existence  of  the  Curb  market, 
notwithstanding  that  these  securities  possess  a  relative  merit 
in  many  cases  as  great  as  those  listed  on  the  regular  exchange. 

"Third,  it  affords  facilities  for  holders  of  securities  that  are 
not  listed  on  either  board  to  get  accurate  quotations  thereon 
and  to  market  their  holdings  quickly  when  so  desired.  The 
Standard  Oil  stocks,  which  admittedly  rank  as  high-class 
issues,  are  included  in  this  group." 

Curb  securities  are  obviously  not  listed;  and,  on  the  whole, 
the  opportunities  for  abuse  and  fraud  are,  therefore,  greater 
than  on  the  regular  Stock  Exchange.  It  is  important  to  note, 
however,  that  many  securities  have  been  graduated  after  a 
period  of  seasoning  from  the  Curb  market  to  the  organized 
Stock  Exchange. 

III.    THE  BROKERAGE  BUSINESS 

The  purchase  and  sale  of  securities  on  the  Stock  Exchange 
is  participated  in  by  the  members  of  the  Exchange  and  their 
agents.  While  for  many  years  the  members  acted  only  in  the 
capacity  of  brokers,  at  the  present  time  many  of  them  are  princi- 
pals as  well  as  agents,  trading  on  their  own  account  as  well  as 
for  their  customers.  The  following  statement  by  a  well-known 
New  York  brokerage  house  outlines  the  methods  by  which 
stock  exchange  operations  are  carried  out : 

I.  Purchasing  outright.  There  are  two  methods  of  buying  or 
selling  stocks  through  members  of  the  New  York  Stock  Exchange, 

'  From  a  pamphlet  by  Edward  E.  Epps  &  Co.,  curb  securities  dealers, 
New  York. 


286         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

viz.,  buying  or  selling  outright  for  cash,  and  buying  or  selling  on 
margin. 

When  purchasing  stock  outright,  or  what  is  commonly  termed 
"for  cash,"  a  person  pays  the  entire  cost  of  the  stock  plus  commission, 
I  of  I  per  cent  (or  12^  cents  per  share).  For  instance,  if  one  pur- 
chased 100  shares  of  United  States  Steel  at  70  he  would  pay  $7,000 
plus  commission,  $12.50,  total  $7,012.50,  and  a  certificate  for  the 
100  shares  would  be  delivered  to  him  in  due  course.  When  stocks 
are  purchased  outright  it  is  customary  to  have  them  transferred  to 
the  name  of  the  buyer,  especially  if  the  stock  is  one  upon  which 
dividends  are  paid,  the  same  being  paid  to  the  party  in  whose  name 
the  certificate  is  made  out.  At  times,  however,  the  purchaser  desires 
to  leave  the  stock  with  the  broker  in  order  to  facilitate  its  sale  when 
desired,  and  the  certificate  is  placed  in  an  envelope  marked  as  property 
of  the  owner  to  be  delivered  when  called  for.  In  this  case  the  stock 
is  often  left  in  the  broker's  name  and  the  customer  is  credited  with 
the  dividend  when  payable,  or  a  check  for  that  amount  is  forwarded 
to  him.  Thus  the  buyer  receives  the  dividend  but  does  not  have  the 
trouble  of  endorsing  the  certificate  and  sending  it  to  the  broker  when 
he  desires  to  sell.  Non-dividend  paying  stocks  when  purchased  out- 
right are  also  often  left  in  the  original  "street  name,"  as  a  certificate 
endorsed  by  a  stock  exchange  house  is  a  good  delivery  at  any  time 
one  may  wish  to  sell  and  he  has  no  trouble  about  endorsing,  wit- 
nessing, etc. 

2.  Purchasing  on  margin.  When  purchasing  on  margin,  the 
broker  buys  the  stock,  paying  for  same  in  full,  but  loans  the  customer 
a  certain  amount,  holding  the  certificates  as  collateral  and  charging 
interest  on  this  debit  balance.  The  difference  between  the  amount 
loaned  and  the  purchase  price  is  deposited  by  the  customer,  being 
what  is  commonly  termed  "margin."  The  customer  may  at  any 
time  pay  off  this  loan,  together  with  any  interest  which  may  have 
accrued  since  the  purchase,  and  take  up  the  stock.  Ten  points,  that 
is,  $10  per  share,  is  the  usual  amount  required  on  a  majority  of 
stocks,  and  the  broker  will  carry  same  as  long  as  the  market  price 
is  sufficient  to  protect  him.  This  does  not  mean  that  he  will 
carry  the  stock  imtil  a  sale  is  made  at  the  exact  limit  of  the 
margin,  however,  as  he  might  not  be  able  to  obtain  that  amount 
if  he  attempted  to  sell.  For  instance,  if  United  States  Steel 
were  purchased  at  70  on  a  lo-point  margin,  the  broker  would 
call  for  additional  margin  when  the  market  price  was,  say,  approxi- 


THE  STOCK  EXCHANGE  AND  CAPITAL  RAISING       287 

mately  65,  and  if  no  further  additional  margin  was  forthcoming  after 
notification,  he  would  hold  same  to  within  from  one  to  two  points  of 
the  limit  or  until  whatever  time  he  might  deem  it  necessary  to  sell 
for  his  own  protection.  The  round  commission  of  J  per  cent  must 
be  figured  out  of  thfe  ten  points,  together  with  whatever  interest 
may  have  accrued  on  the  money  loaned.  Many  figure  that  stock 
is  held  to  the  exact  limit  of  the  margin,  but  it  must  be  remembered 
that  while  there  might  still  be  a  margin  of  a  fraction  or  even  a  point 
at  the  close  of  the  day,  the  market  might  open  off  more  than  that 
the  next  morning  and  the  broker  be  unable  to  close  out  the  commit- 
ment except  at  a  loss  to  himself.  Many  of  the  inactive  stocks  also 
have  wide  quotations,  and  sales  might  be  one,  two,  or  three,  or  more 
points  apart,  thus  affording  no  opportimity  to  sell  at  the  desired 
figure.  The  distance  which  a  stock  will  be  carried  depends  to  a 
great  extent  upon  the  condition  of  the  market  and  the  character  of 
the  stock.  Even  active  stocks  which  in  ordinary  times  would  be 
carried  to  within  from  one  to  two  points  of  exhaustion  could  not  be 
carried  on  such  a  small  margin  in  panicky  times  when  there  is  a 
chance  that  they  might  open  off  several  points  the  following  morn- 
ing. A  customer  is,  of  course,  always  given  every  opportunity  to 
deposit  additional  margin,  which  should  always  be  done  when  it  has 
been  reduced  to  approximately  five  points,  whether  a  margin  call 
is  received  or  not,  it  being  assumed  that  a  person  either  long  or  short 
of  stock  is  sufficiently  interested  to  keep  track  of  market  movements. 
There  is  no  limit  to  the  length  of  time  stocks  may  be  carried  on 
margin  as  long  as  the  amount  of  margin  is  sufficient  to  protect  the 
.broker. 

We  have  endeavored  to  point  out  the  features  of  marginal  trading 
which  ofttimes  lead  to  discussion  and  annoyance  to  both  broker  and 
customer,  but  if  a  customer  vmderstands  marginal  requirements 
fully,  it  is  often  the  most  convenient  and  profitable  manner  of  trading 
if  conservatism  is  observed.  For  instance,  one  may  believe  that  a 
certain  stock  is  due  for  an  advance  and  have  only  sufficient  funds 
to  purchase,  say,  50  shares,  but  is  enabled  to  take  100  shares  by 
borrowing  the  difference  from  the  broker.  When  the  stock  advances 
he  may  procure  just  double  the  profits  he  would  have  if  the  stock 
were  purchased  outright.  He  thus  has  a  50  per  cent  margin,  which 
should  be  a  very  conservative  amount  on  a  stable  stock  and  is  in 
the  same  position  as  a  man  who  purchases  a  house  and  secures  a 
mortgage  thereon. 


288         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

We  would  require  ten  points  ($io  per  share)  margin  on  a  majority 
of  stocks,  but  will  accept  five  points  on  some  low-priced  issues  having 
a  ready  market  for  purchase  or  sale,  although  even  more  than  ten 
points  is  often  necessary  on  some  of  the  very  high  priced  shares,  or 
stocks  which  have  a  very  wide  market,  that  is,  in  cases  where  the 
bid  and  asked  prices  are  far  apart  and  fluctuation  apt  to  be  abnormal. 
If  only  this  minimum  amount  be  provided  for,  one  may  obtain 
profits  many  times  as  great  as  if  purchasing  the  stock  outright,  but 
we  always  endeavor  to  impress  upwn  our  customers  the  advantage  of 
a  heavier  margin.  The  greater  the  number  of  points  with  which 
a  customer  fortifies  his  account,  the  greater  is  his  protection  against 
possible  adverse  market  movements. 

3.  Selling  outright.  In  selling  stock  held  outright  in  a  customer's 
name,  the  customer  must  endorse  the  certificate,  spelling  the  name 
exactly  as  it  is  spelled  on  the  face  and  have  same  witnessed,  but 
should  fill  in  none  of  the  other  blank  spaces  on  the  back  of  the  certif- 
icate. The  commission  for  selling  is  the  same  as  for  buying,  and  in 
addition  the  seller  pays  taxes  of  4  cents  per  every  $100  par  value, 
which  is  levied  by  the  state  of  New  York  and  the  federal  govern- 
ment. 

4.  Selling  margin  stock.  When  selling  stock  is  held  on  margin, 
the  customer  simply  gives  the  order  to  the  broker,  who  sells  the  stock, 
delivers  the  certificate,  and  credits  the  customer's  account  with  the 
proceeds,  less  commission  and  state  and  federal  taxes. 

In  selling  stock  short,  the  broker  sells  the  stock,  borrows  it,  and 
delivers  same  on  regular  delivery  day.  The  margin  required  is  the 
same  as  when  purchasing  stock,  but  is  a  protection  against  a  rise  in 
the  market  instead  of  a  decHne.  If  the  market  reacts,  the  customer 
may  repurchase  the  stock  at  a  lower  figure,  his  profits  being  the 
difference  between  the  sale  price  and  the  purchase  price,  and  if  the 
market  advances  and  he  buys  in,  or  "covers,"  at  a  higher  figure, 
his  loss  is  also  the  difference  between  the  sale  price  and  the  purchase 
price.  This  is  simply  the  reverse  of  purchasing  stock  and  then  selling, 
the  sale  being  made  first  and  the  purchase  later.  When  the  stock  is 
covered,  the  broker  returns  same  to  the  party  from  whom  he  originally 
borrowed  it.  No  interest  is  charged  a  customer  on  the  transaction, 
except  when  the  stock  is  loaning  at  a  premium  because  of  a  great 
scarcity;  that  is,  when  he  is  forced  to  pay  a  certain  amount  for  the 
privilege  of  borrowing  the  stock.  This,  however,  is  a  very  rare 
occurrence. 


THE  STOCK  EXCHANGE  AND  CAPITAL  RAISING       289 

5.  Deliveries.  When  stock  is  bought  or  sold,  the  certificate  is 
not  delivered  until  the  following  day,  at  which  time  the  purchasing 
broker  pays  the  seUing  broker  the  amount  due.  Stocks  or  bonds 
purchased  on  Friday  or  Saturday  are  not  deliverable  until  Monday, 
as  Saturday  is  a  non-delivery  day.  It  is  necessary  for  the  broker  to 
receive  from  a  customer  at  least  a  deposit  against  the  purchase  of 
the  stock  before  the  stock  is  bought,  as  he  obligates  himself  to  take 
the  stock  from  the  other  broker  on  the  regular  deliverj'^  day,  and  if 
any  unforeseen  accident  occurs  to  the  customer  overnight,  preventing 
him  from  paying  for  the  stocks,  the  broker  would  have  to  take  it 
himself  and  stand  any  loss  which  might  be  incurred  by  a  possible 
decline  in  the  market  price.  When  stock  is  sold,  payment  is  not 
received  until  the  next  day,  when  it  is  delivered.  It  is  necessary, 
however,  for  the  broker  to  have  the  stock  in  his  possession  before 
selling,  unless  it  is  a  short  transaction. 

6.  Stop  loss  orders.  Stop  loss  orders  are  used  by  a  great  many 
traders  to  limit  the  amount  of  possible  loss  on  any  transaction  and 
ofttimes  save  one  from  losing  his  entire  margin.  A  stop  loss  order 
for  the  purchase  or  sale  of  a  stock  means  that  the  purchase  or  sale, 
as  the  case  may  be,  is  to  be  made  "at  the  market"  when  a  certain 
price  is  reached.  For  instance,  if  United  States  steel  is  selling  at  70, 
and  an  order  is  placed  to  sell  one  hundred  shares  at  68  stop,  it  means 
that  when  a  sale  of  one  hundred  shares  or  more  is  made  on  the  Stock 
Exchange  at  68  or  less,  100  shares  are  to  be  sold  "at  the  market,"  that 
is,  at  the  best  price  obtainable.  At  times,  however,  it  might  close 
above  68  one  day  and  open  below  68  the  next  morning,  or  even  during 
the  day  might  break  from  a  price  above  to  below  68  without  a  sale  at 
that  figure,  in  which  case  the  stop  loss  order  would  be  executed  as 
soon  as  a  sale  was  made  under  68.  Conversely,  if  an  order  is  given 
to  buy  100  shares  at,  say,  72  stop,  it  means  that  100  shares  are  to 
be  purchased  "at  the  market"  when  a  sale  of  100  shares  or  more  is 
made  at  72  or  higher. 

7.  Commissions  and  other  charges.  Our  commission  charges  for 
transacting  on  the  Stock  Exchange  are  \  per  cent  for  buying  and 
\  per  cent  for  selling,  which  is  equal  to  i2§  cents  per  share^^except 
in  the  case  of  mining  shares  selling  below  $10,  upon  which  the  charge 
is  tV  per  cent,  but  the  minimum  charge  upon  any  transaction  is  $1.  The 
commission  on  outside  securities  varies  according  to  the  selling  price. 

Interest  is  charged  on  any  unpaid  balances,  the  rate  being 
governed  by  the  prevailing  money  rates,  the  size  and  activity  of  the 

^This  charge  is  now  15  cents  per  share, 


290  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

account,  the  amoiint  of  margin  maintained,  and  the  character  of  the 
stock  in  question,  having  ranged  from  3  per  cent  to  6  per  cent  during 
the  past  year.'  We  can,  of  course,  make  more  favorable  rates  upon 
stocks  which  we  can  readily  place  in  loans  with  a  bank  than  on  those 
upon  which  we  cannot  borrow  money,  and  must,  therefore,  lie  idle 
in  our  safe  deposit  vault. 

Interest  is  credited  the  customer  on  daily  balances  of  over  $500 
which  are  awaiting  investment.  Aside  from  the  fact  that  we  require 
a  deposit  on  all  orders  many  find  it  both  convenient  and  profitable 
to  leave  their  funds  on  deposit  with  us  pending  stock  or  bond  trans- 
actions, inasmuch  as  they  receive  interest  on  daily  balances,  whereas 
at  times  they  lose  interest  when  they  have  to  withdraw  their  funds 
from  a  savings  bank,  where  interest  is  allowed  only  on  money  left 
until  a  certain  date. 

Broker's  organizations  make  it  possible  to  speculate  by  wire. 
A  large  part  of  all  the  stock  bought  and  sold  in  the  Wall  Street 
offices  of  brokerage  firms  is  of  course  for  the  account  of  operators 
who  live  in  New  York.  But  in  addition  to  this  the  large 
brokerage  concerns  have  a  remarkably  extensive  telegraph 
system  whereby  orders  are  gathered  from  far  distant  points. 
The  "wire  map"  of  any  one  of  a  half-dozen  or  so  of  the  large 
houses  looks  like  a  complete  railroad  guide  of  the  United 
States.  One  particular  firm  reaches  by  private  leased  duplex 
wire  from  its  main  Wall  Street  office  to  such  cities  as  Baltimore, 
Washington,  Charlotte,  Charleston,  Atlanta,  Savannah, 
Augusta,  Jacksonville,  New  Orleans,  Memphis,  Chicago, 
Cleveland,  Cincinnati,  Omaha,  Colorado  Springs,  Denver, 
Salt  Lake  City,  Butte,  Spokane,  San  Francisco,  Pasadena,  Los 
Angeles,  Coronado  Beach,  and  San  Diego.  It  also  has  wire 
connections  to  Boston,  Portland,  Montreal,  Toronto,  Detroit, 
Gary,  Indianapolis,  Louisville,  St.  Louis,  Kansas  City,  Mil- 
waukee, St.  Paul,  and  Winnipeg.  This  particular  firm  has 
six  branches  in  the  state  of  California  alone.  These  wires  may 
connect  with  branch  offices  or  merely  with  correspondent  firms. 

The  relative  importance  of  this  outside  business  may  be 
judged  from  the  following  figures.    On  two  successive  days  in 

•This  was  written  in  1916.  With  the  present  (1920)  enormously  high 
money  r^tes  the  charges  are  proportionately  hi^er. 


THE  STOCK  EXCHANGE  AND  CAPITAL  RAISING       291 

the  summer  of  1919,  75,000  and  60,000  shares  respectively 
were  handled  by  branch  offices;  while  38,000  and  46,000 
shares  respectively  were  handled  by  the  main  office  in  New  York/ 
The  extent  of  this  "outside"  participation  in  New  York  Stock 
Exchange  speculation  is,  of  course,  very  much  increased  in  times 
of  active  bull  markets,  such  as  prevailed  in  the  early  summer 
and  again  in  the  autumn  of  19 19. 

Brokerage  offices  are  storehouses  of  information.  These 
brokerage  houses  render  a  great  deal  of  service  both  to  specula- 
tors and  investors.  Through  weekly  market  letters  sent  out  to 
■their  customers,  they  furnish  reliable  information  bearing  on 
inactive  and  unlisted  securities;  they  give  the  history  of  the 
corporations  issuing  particular  securities,  together  with  a  survey 
of  the  commodities  markets  and  other  pertinent  facts  as  they 
relate  to  the  values  of  the  issues  in  question;  they  present 
general  data  on  stock  market  developments  of  the  week; 
and  they  discuss  (often  with  no  little  bias)  the  probable  trend 
of  the  market  in  the  light  of  general  economic  and  financial 
conditions. 

Some  of  the  brokerage  concerns  which  deal  in  highly  specu- 
lative issues  traded  in  on  the  Curb  and  the  Consolidated  Ex- 
change have  developed  elaborate  organizations.  For  instance, 
one  of  the  large  houses  engaged  in  the  marketing  of  "Curb, 
mining,  oil,  and  industrial  securities"  has  a  large  number  of 
branch  offices  in  various  parts  of  the  United  States  connected 
with  the  main  office  by  a  leased  wire  system.  It  secures  "  wire  " 
news  relating  to  the  industries  in  question  from  correspondents 
in  the  field,  and  it  distributes  a  weekly  market  letter,  containing 
from  7,000  to  10,000  words,  to  between  15,000  and  20,000 
investors,  actual  and  potential.  It  has  also  developed  a  report 
system,  which,  as  a  result  of  several  years  of  accumulation, 
affords  a  fairly  comprehensive  record  of  mining  history  in  this 
country.  From  these  data  special  reports  are  made  to  interested 
clients  on  the  history  of  mining  corporations.  One  company 
avers  that  it  is  "prepared  at  a  few  hours'  notice  to  furnish 

'  Data  taken  from  an  article  by  Albert  W.  Atwood,  Saturday  Evening 
Post,  June  21,  1919. 


292         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

complete  detailed  reports  on  more  than  750  mining  securities" — 
reports  which  embrace  corporate  history,  financial  and  physical 
statistics,  details  of  mine  development,  including  estimates  of 
tonnage,  progress  of  the  work,  and  equipment.  Upon  written 
request  it  issues  to  interested  clients  special  letters  and  special 
telegrams  bearing  on  developments  affecting  the  value  of  their 
holdings. 

There  is  need  of  more  adequate  regulation  of  the  brokerage 
husiness.  Evils  arise,  however,  in  connection  with  many  of 
these  brokers,  for  there  is  opportunity  for  fraud  here,  as  in  the 
case  of  the  sale  of  securities  for  investment  purposes.  The 
literature  sent  out  by  "fly-by-night"  brokerage  houses  makes 
quite  as  interesting  and  instructive  reading  as  that  of  the 
promoter  of  speculative  and  fraudulent  companies,  and  the 
losses  of  the  victims  of  such  alluring  literature  are  quite  as 
stupendous  as  those  of  the  dupes  of  promotion  swindles.  There 
are  many  brokerage  houses  which  have  been  in  existence  for  a 
generation,  whose  fraudulent  dealings  have  eventually  been 
made  the  basis  for  legal  action  and  penalty. 

Among  the  evils  of  the  brokerage  business  must  be  noted 
the  operations  of  the  so-called  bucket-shops.  These  are 
ostensibly  brokerage  offices;  but  securities  are  neither  bought 
nor  sold  in  pursuance  of  customers'  orders,  the  transactions 
being  closed  by  the  payment  of  gains  or  losses  as  determined  by 
price  quotations.  They  are  thus  merely  places  for  the  regis- 
tration of  bets  or  wagers.  The  bucket-shop  machinery,  more- 
over, is  generally  controlled  by  the  keeper,  who  is  in  a  position 
to  delay  or  manipulate  the  quotations  at  will.  Despite  the 
fact  that  bucket-shops  are  illegal  and  that  their  operators  are 
punishable  by  fine  and  imprisonment,  it  has  been  very  difficult 
to  check  their  operations,  particularly  in  periods  of  great 
speculative  activity. 


THE  STOCK  EXCHANGE  AND  CAPITAL  RAISING       293 

IV.    ECONOMIC  FUNCTIONS  OF  THE  STOCK 
EXCHANGE 

The  stock  market  makes  possible  investments  for  short  periods. 
The  functions  performed  by  the  organized  stock  exchanges  in 
connection  with  the  raising  of  capital  for  corporations  are 
numerous.  In  the  first  place,  the  fact  that  the  exchange  pro- 
vides a  market  where  shares  and  bonds  can  be  readily  disposed 
of  induces  a  great  deal  of  investment  in  securities  that  would 
otherwise  not  occur.  Many  individuals,  business  firms,  and 
corporations  have  on  hand  funds  that  are  temporarily  not 
required,  either  because  of  seasonal  variations  in  the  volume 
of  business  or  a  general  dulness  of  trade.  By  virtue  of  an 
organized  market  these  funds  may  be  invested  in  securities, 
with  assurance  that  the  securities  can  at  any  time  be  recon- 
verted into  cash  at  the  market  price  then  current.  In  the 
absence  of  the  stock  market  these  funds  would  either  remain  in 
idleness  or  be  deposited  in  commercial  or  savings  banks,  where 
the  interest  return  would  be  substantially  lower. 

It  may  be  noted,  in  passing,  that  the  operations  of  commercial 
and  savings  banks  and  insurance  companies  are  to  a  large  extent 
dependent  upon  the  Stock  Exchange,  In  providing  a  market 
for  securities  it  makes  it  possible  for  these  financial  institutions 
to  accept  the  funds  of  customers,  convert  them  into  paying 
investments  with  the  risks  widely  distributed,  and  yet  remain 
in  a  position  to  pay  depositors  on  demand  or  short  notice  and  to 
meet  insurance  obligations  with  promptness  and  certainty. 
The  relation  of  the  commercial  bank  to  the  stock  market  will 
be  more  fully  discussed  in  chapter  xxiv  below. 

The  stabilization  of  securities^  values  safeguards  and  pro- 
motes investment.  In  the  second  place,  the  activities  of  specula- 
tors result  in  price  quotations  which  reflect  with  a  fair  degree 
of  accuracy  the  relative  investment  merits  of  different  types 
of  securities.  Specialized  financial  experts  devote  their  energies 
unceasingly  to  a  scrutiny  of  values;  "bulls  and  bears,  bankers 
and  brokers,  speculators  and  investors,  all  over  the  world  bid 
and  offer  against  each  other  by  cable  and  telegraph  and  record 


204         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  epitomized  result  of  their  bidding  in  the  prices  current  on 
the  stock  exchange." 

While  personal  gain  is  the  motive  of  these  speculators,  the 
net  result  of  their  activities  is  to  give  general  stability  to  stock 
market  prices  and  to  reveal  the  relative  investment  values  of 
the  different  issues.  It  is  to  be  noted  that  the  larger  the  number 
of  operations  and  the  greater  the  number  of  securities  traded  in 
on  the  various  exchanges,  the  more  accurate  becomes  the  stock 
exchange  index  of  values. 

The  effect  of  this  is  also  to  stabilize  the  prices  of  securities 
in  different  markets.  This  is  most  clearly  revealed  in  con- 
nection with  international  securities,  such  as  the  bonds  of  the 
principal  governments  and  of  large  corporations,  like  the 
Pennsylvania  Railroad  and  the  General  Electric  Company  of 
Germany.     For  bonds  of  this  class 

the  telegraph  keeps  prices  at  almost  exactly  the  same  level  in  all  the 
stock  exchanges  of  the  world.  If  the  price  of  one  of  them  rises  in 
New  York  or  in  Paris,  in  London  or  in  Berlin,  the  mere  news  of  the 
rise  tends  to  cause  a  rise  in  other  markets;  and  if  for  any  other  reason 
the  rise  is  delayed,  that  particular  class  of  bonds  is  Ukely  soon  to  be 
offered  for  sale  in  the  high-priced  market  under  telegraphic  orders  from 
the  other  market,  while  dealers  in  the  first  market  will  be  making 
telegraphic  purchases  in  other  markets.  These  sales  on  the  one  hand, 
and  piu-chases-on  the  other,  strengthen  the  tendency  which  the  price 
has  to  seek  the  same  level  everywhere ;  and  unless  some  of  the  markets 
are  in  an  abnormal  condition,  the  tendency  soon  becomes  irresistible.' 

This  equalization  of  values  in  different  markets,  with  the 
published  price  quotations  of  all  the  securities  traded  in,  makes 
it  possible  for  an  individual,  wherever  located,  to  buy  or  sell 
securities  at  prices  which  reflect  fundamental  values.  Thus 
the  holder  of  securities  listed  on  the  Stock  Exchange  is 

exposed  to  no  fraud  and  is  at  the  mercy  of  no  rumor  and  no 
unscrupulous  dealer.  He  has  positive  assurance  that  in  case  of 
necessity,  at  a  moment's  notice,  he  can  obtain  at  the  prevailing 
price  the  value  in  cash  of  every  stock  exchange  security  in  his  box. 
The  ticker  gives  him  instantaneous  quotations;  all  the  newspapers 

«  Alfred  Marshall,  Principles  of  Economics,  I  (4th  edition,  1898),  403. 


THE  STOCK  EXCHANGE  AND  CAPITAL  RAISING       295 

publish  authorized  prices  for  his  benefit He  knows,  more- 
over, that  the  price  thus  established  is  not  merely  the  opinion  as  to 
value  today,  but  that  it  represents  a  critical  look  into  the  future.' 

The  result  of  this  stabilizing  of  securities'  values  and  the 
publishing  of  quotations  is  to  encourage  the  investment  of  funds 
in  corporate  securities  by  great  numbers  of  people  who  would 
otherwise  not  be  in  a  position  to  ascertain  with  any  degree  of 
accuracy  what  price  should  be  paid  for  securities  and  who  would 
also  be  unable  to  protect  themselves  from  fraud  and  sharp 
deahngs.  It  also  promotes  the  development  of  a  world  financial 
organization,  the  concrete  evidence  of  which  is  best  shown  by 
reference  to  tlie  list  of  over  eleven  hundred  securities  which  are 
traded  in  on  the  London  Stock  Exchange,  representing  industries 
in  all  parts  of  the  world. 

The  service  of  pecuniary  accounts  in  directing  the  flow  of 
capital  is  made  effective  by  means  of  the  stock  exchange.  In  the 
third  place,  the  stock  market  facilitates  the  profitable  distribu- 
tion of  capital  among  different  industries,  among  different 
plants  in  a  given  industry,  and  among  different  countries  and 
regions  of  the  world.  In  chapter  ii  we  discussed  the  role  of 
the  pecuniary  unit  in  this  connection.  It  is  now  in  point  to 
note  that  the  distribution  is  worked  out  through  the  purchase 
and  sale  of  shares  of  stock  and  bonds  which  find  quotations  in 
terms  of  the  pecuniary  unit  on  the  organized  exchanges.  The 
fluctuations  in  the  prices  of  different  securities,  being  reflections 
of  fundamental  underlying  conditions,  indicate  in  general  in 
what  directions  capital  can  find  its  most  profitable  investment. 
If  the  earnings  of  the  railroad  companies  are  low  and  the  outlook 
for  the  future  dark,  the  low  prices  of  bonds  and  shares  resulting 
from  speculative  activities  make  it  clear  to  investors  that  rail- 
roads do  not  offer  a  promising  field  for  future  investment. 
Incidentally  it  is  also  made  clear  to  rate-controlling  commissions 
that,  if  capital  is  to  be  attracted  into  the  railroad  industry, 
rates  must  be  readjusted  to  a  level  which  will  permit  railroad 
profits.    If,  on  the  other  hand,  the  earnings  of  automobile 

'  Van  Antwerp,  The  Stock  Exchange  from  Within,  p.  22. 


296  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

concerns  are  very  large,  the  high  prices  of  automobile  securities 
indicate  the  opportunity  for  large  profits  in  the  automobile 
industry  and  capital  is  attracted  into  that  line.  The  stock 
market  index  of  values  thus  facihtates  the  movement  of  capital 
to  the  places  of  greatest  temporary  demand. 

While  there  are  often  miscalculations  and  over-hopeful  esti- 
mates of  the  future,  and  while  there  may  at  times  be  manipulation 
which  results  in  a  false  picture  of  the  situation,  the  nature  of 
the  service  that  is  performed  in  this  connection  by  the  stock 
exchange  will  be  clear  if  one  reflects  as  follows: 

Suppose  for  a  moment  that  the  stock  markets  of  the  world  were 
closed,  that  it  was  no  longer  possible  to  learn  what  railways  were 
paying  dividends,  what  their  stocks  were  worth,  how  industrial 
enterprises  were  faring — whether  they  were  loaded  up  with  surplus 
goods  or  had  orders  ahead.  Suppose  that  the  information  afforded 
by  public  quotations  on  the  ....  exchanges  were  wiped  from 
the  slate  of  human  knowledge;  how  would  the  average  man,  how 
would  even  a  man  with  tHe  intelligence  of  a  Pierpont  Morgan, 
determine  how  new  capital  should  be  invested  ?  He  would  have  no 
guide  except  the  most  isolated  facts  gathered  here  and  there  at  great 
trouble  and  expense.  A  greater  misdirection  of  capital  and  energy 
would  result  than  has  been  possible  since  the  organization  of  modern 
economic  machinery.' 

Stock  speculation  '^carries''  and  ''tests"  the  merits  of  unsea- 
soned securities.  Finally,  one  of  the  greatest  functions  of  the 
stock  exchange  is  that  of  "carrying"  masses  of  new  securi- 
ties during  their  seasoning  period.  In  the  event  that  a  new 
issue  of  securities  does  not  go  well  and  remains  unsold  at  the 
expiration  of  the  underwriting  agreement,  it  becomes  necessary 
for  the  underwriters  either  to  carry  these  securities  on  borrowed 
funds  in  the  hope  of  a  favorable  turn  in  the  market  or  to  sell 
them  at  a  convenient  opportunity  and  pocket  their  losses.  The 
stock  market  provides  the  means  either  for  holding  or  disposing 
of  the  securities. 

If  the  underwriters  decide  to  carry  the  securities,  they 
must,  as  indicated  in  the  preceding  chapter,  borrow  heavily 

'  Charles  A.  Conant,  Wall  Street  and  the  Country,  pp.  02-93. 


THE  STOCK  EXCHANGE  AND  CAPITAL  RAISING      297 

from  the  commercial  banks.  This  they  are  enabled  to  do  only 
because  the  stocks  and  bonds  in  which  they  are  dealing  are  a 
satisfactory  collateral  security  for  bank  loans,  in  consequence 
of  their  ready  salabiUty  through  the  mechanism  provided  by 
the  stock  exchange.  In  case  the  underwriters  elect  to  dispose 
of  their  holdings,  it  is  obvious  that  the  stock  market  provides 
the  opportunity. 

The  securities  that  are  unloaded  by  the  underwriters, 
moreover,  become  subject  to  speculative  activities,  largely 
through  "margin"  trading,  with  the  commercial  banks  again 
furnishing  a  large  percentage  of  the  funds  required.  Many 
securities,  particularly  those  of  a  highly  speculative  nature, 
are  also  traded  in  on  the  curb  before  any  of  them  are  purchased 
for  investment,  these  operations  again  being  made  possible 
mainly  by  margin  trading  on  borrowed  funds. 

These  unmarketed,  or  "undigested,"  securities  may  remain 
subject  to  speculative  activity  for  considerable  periods  of  time, 
not  infrequently  for  several  years,  depending  upon  the  state  of 
the  investment  market  and  the  character  of  the  security  in 
question.  This  speculation,  conducted  with  funds  borrowed 
from  commercial  banks  on  amply  margined  collateral  security, 
thus  makes  it  possible  for  a  corporation  to  procure  the  funds 
required  in  developing  its  business,  even  though  its  securities 
do  not  as  yet  commend  themselves  to  ultimate  investors. 
The  corporation  is  thus  enabled  gradually  to  demonstrate  by 
industrial  achievement  its  merits  as  an  enterprise.  Meanwhile 
the  subjecting  of  its  securities  to  the  test  of  speculation  gradually 
serves  to  indicate  their  actual  value  and  thus  to  induce  indi- 
viduals to  "pick  them  up"  for  investment  purposes. 

It  should  be  observed  that  at  this  place  the  analysis  ties 
back  with  that  in  the  chapter  on  the  marketing  of  low-grade 
or  speculative  securities.  Here  is  clearly  one  way  of  raising 
capital  for  untried  enterprises  that  does  not  place  the  risks 
upon  the  investing  public.  It  is,  moreover,  a  method  of 
very  great  importance;  for  many  of  the  high-grade  stocks  of  the 
present  time  that  are  held  largely  by  investors,  have  passed 
through  a  probationary  period  as  purely  speculative  issues. 


298        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

It  has  been  estimated,  indeed,  that  stock  speculation  served  as 
a  means  of  furnishing  probably  the  largest  share  of  the  fixed 
capital  that  was  used  in  the  great  period  of  industrial  expansion 
following  1898.  The  volume  of  stocks  and  bonds  that  was 
annually  being  issued  by  new  corporations  far  outran  the 
absorbing  power  of  the  investment  market,  and  hundreds  of 
millions  in  securities  could  not  be  sold  to  ultimate  investors. 
The  National  City  Bank  of  New  York  estimates  that  in  1900 
over  60  per  cent  of  the  stock  of  our  largest  corporations  whose 
securities  were  listed  on  the  New  York  Stock  Exchange  was 
held  in  the  names  of  stock  brokerage  houses  and  represented 
speculative  accounts.  "The  history  of  the  capitalization  of 
our  leading  corporations  shows  that  new  stock  issues  almost 
invariably  run  through  a  period  in  which  they  are  largely  held 
by  the  speculative  public  in  brokers'  names  (on  funds  borrowed 
from  the  commercial  banks),  the  proportion  so  held  gradually 
diminishing  through  a  number  of  years  as  the  investment 
buyers  gradually  purchase  them  to  keep. " 

Stock  markets,  investment  banks,  commercial  banks, 
speculators,  and  investors  are  thus  intricately  related  to  the 
process  of  marketing  corporate  securities;  and  the  entire 
mechanism  would  break  down  if  any  of  its  interdependent 
parts  should  cease  to  function.  In  the  absence  of  a  securities' 
market  borrowing  corporation  and  investing  public — including 
savings  banks  and  insurance  companies — would  alike  be  with- 
out an  indispensable  index  of  relative  values.  Without  both 
the  stock  market  and  the  commercial  banking  system,  under- 
writers and  distributors  of  securities  would  find  it  impossible 
to  conduct  their  operations.  The  stock  market  could  not 
perform  its  function  in  "carrying  and  testing"  unseasoned 
securities  in  the  absence  of  commercial  bank  loans  to  specu- 
lators; and  the  commercial  banks,  in  turn,  could  not  make 
loans  to  speculators  if  it  were  not  for  the  stock  exchange,  which 
at  once  indicates  the  value  of  the  collateral  offered  as  security 
for  the  loans  and  makes  possible  its  ready  sale  in  case  of  need. 
The  full  significance  of  the  part  that  the  commercial  banks 
play  in  the  process  cannot,  however,  be  made  clear  until  we  have 


THE  STOCK  EXCHANGE  AND  CAPITAL  RAISING       299 

studied  the  commercial  banking  mechanism  in  some  detail. 
We  shall  also  find  that  the  stock  exchange  performs  a  very 
important  r61e  in  connection  with  the  raising  of  working  capital. 

QUESTIONS  FOR  DISCUSSION 

1.  "The  Stock  Exchange  provides  a  market  for  the  purchase  and 
sale  of  securities  of  relatively  high  grade.  The  Curb  and  the 
Consolidated  Exchange  fiumish  a  market  place  for  the  piurchase 
and  sale  of  securities  of  low  grade  and  in  small  lots."  Do  you 
think  that  the  Consolidated  Exchange  and  the  Curb  market  are 
less  important  than  the  Stock  Exchange  ? 

2.  Show  in  what  way  the  stock  market  is  of  service  to  each  of  the 
financial  institutions  with  which  it  is  connected  in  the  chart 
on  page  136. 

3.  Do  the  requirements  for  listing  stock  on  the  New  York  Stock 
Exchange  insure  that  the  stocks  quoted  wiU  have  a  high  value  ? 
Precisely  what  is  the  advantage  of  these  "hsting"  requirements  ? 

4.  What  is  meant  by:  bulls?  bears?  speculators?  brokers? 

5.  What  is  meant  by  short  selling  ?  How  is  delivery  of  the  securities 
effected  ? 

6.  If  short  seUing  were  prohibited,  would  there  be  as  accurate  an 
adjustment  of  the  prices  of  securities  to  their  real  values  ? 

7.  Would  it  be  possible  to  have  a  stock  market  and  quotations  of 
shares  without  a  pecuniary  unit  of  values  ? 

8.  What  is  meant  by  margin  trading  ?    Of  what  significance  is  it  ? 

9.  What  sources  of  information  as  to  stock  and  bond  values  are 
available  for  the  general  pubUc  ? 

10.  Consult  the  financial  section  of  your  daily  newspaper,  the  Com- 
mercial and  Financial  Chronicle,  the  New  York  Evening  Post 
(Saturday  edition),  and  the  Wall  Street  Journal;  and  write  a 
statement  of  the  nature  of  the  information  there  available. 

11.  Are  the  weekly  market  letters,  daily  newspaper  quotations, 
special  quick  news,  and  "ticket  services"  of  importance  to  the 
investor  or  only  to  the  speculator  ? 

12.  What  are  the  services  rendered  by  brokerage  houses?  How  do 
they  make  their  earnings  ? 

13.  What  is  the  purpose  of  the  leased  wire  system? 

14.  What  are  bucket  shops?  Specifically  how  do  they  differ  from 
brokerage  oflSces  ? 


30O         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

15.  Show  concretely  how  the  stock  exchange  aids  in  directing  the 
distribution  of  capital. 

16.  If  the  stock  market  indicates  that  larger  returns  are  to  be  derived 
from  investments  in  industries  that  are  manufacturing  luxuries 
than  in  those  that  are  producing  necessities,  and  capital  (and 
labor)  are  in  consequence  directed  in  increasing  amounts  to  the 
luxuries  trades,  is  the  result  necessarily  socially  advantageous  ? 

17.  Enximerate  as  many  groups  of  people  or  institutions  as  possible 
that  make  use  of  the  stock  exchange. 

18.  In  what  ways  does  the  stock  exchange  promote  investment  ? 

19.  "If  it  were  not  for  speculation  in  securities,  a  large  percentage  of 
the  issues  of  newly  organized  corporations  would  not  be  ulti- 
mately absorbed . "    Why  ? 

20.  Several  years  of  speculation  often  result  in  the  adjusting  of  stock 
prices  at  a  very  low  figure,  due  to  the  low  earning  power  of  the 
issuing  corporation.  In  a  case  of  this  kind,  speculation  finally 
ceases,  and  it  is  imp)ossible  to  induce  the  investing  public  to 
purchase  the  securities  for  investment.  Who  has  borne  the 
loss  in  such  a  case?  What  is  the  economic  advantage  of  such 
speculation  ? 

REFERENCES  FOR  FURTHER  READING 

Conant,  Charles  A. :  Wall  Street  and  the  Country. 

Emery,  Henry  C:  Speculation  on  the  Stock  and  Produce  Ex- 
changes of  the  United  Slates. 

Fayant,  Frank  H.:  Some  Thoughts  on  Speculation. 

Van  Antwerp,  William  C. :   The  Stock  Exchange  from  Within. 

Report  of  Governor  Hughes's  Committee  on  Speculation  in 
Securities  and  Commodities  (1909).  Published  in  Money  Trust 
Investigation,  1913. 


CHAPTER  XVII 

TRUST   COMPANIES   AND  THE  MODERN 
FINANCIAL  SYSTEM 

In  many  respects  the  most  interesting  financial  institution 
of  the  present  day  is  the  trust  company.  The  growth  of  these 
institutions,  called  into  being  to  meet  the  diverse  requirements 
of  a  capitalistic  economic  system,  has  been  nothing  short  of 
phenomenal  during  the  past  forty  years,  and  especially  since 
the  era  of  financial  consohdation  which  began  with  the  turn  of 
the  century.  Popularly  confused  with  the  type  of  business 
organization  that  was  declared  illegal  under  the  Sherman  Anti- 
Trust  law,  the  trust  company  is,  in  truth,  only  a  new  kind  of 
financial  institution  that  has  developed  to  fill  the  gaps  in  a 
hitherto  incomplete  financial  structure.  In  the  course  of  its 
evolution,  however,  it  has  not  only  roimded  out  the  financial 
system;  it  has  invaded  the  field  of  most  of  the  other  financial 
institutions  as  well.  The  trust  company  has  thus  been  feUci- 
tously  designated  "the  department-store  of  finance,"  and  "the 
omnibus  of  financial  institutions." 

The  first  trust  companies  in  the  United  States,  organized 
early  in  the  last  century,  combined  the  business  of  insurance 
with  that  of  trustee  for  individuals  and  estates.  Now,  however, 
all  forms  of  insurance  except  fideUty  and  suretyship  have  been 
taken  over  by  the  regular  insurance  companies;  and  even  these 
two  are  more  and  more  being  surrendered  to  specialized  fidelity 
institutions.  Although  the  rapid  increase  in  the  number  and 
size  of  private  fortunes  and  estates  in  the  second  half  of  the 
nineteenth  century  has  greatly  expanded  the  volume  of  trustee 
business  for  individuals,  it  has  been  the  growth  of  the  corpora- 
tion which  has  given  the  trust  company  its  largest  and  most 
distinctive  field  of  enterprise.  The  great  variety  of  ways  in 
which  the  trust  company  is  of  service  to  the  corporate  system 
of  finance  will  be  revealed  below. 

301 


502         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

I.    THE  SCOPE  OF  TRUST  COMPANY  OPERATIONS 

The  nature  and  variety  of  financial  operations  engaged  in 
by  trust  companies  may  be  seen  from  a  summary  of  the  powers 
conferred  upon  such  institutions  by  the  law  of  the  state  of 
New  York: 

1.  Banking:  A  trust  company  may 

a)  Receive  deposits  of  money. 

b)  Lend  money  on. real  or  personal  securities. 

c)  Accept  for  payment  at  a  future  date  drafts  drawn  upon 
it  by  its  customers. 

d)  Buy  and  sell  exchange,  coin,  and  bullion. 

e)  Discount  and  negotiate  drafts,  promissory  notes,  bills  of 
exchange,  and  other  evidences  of  indebtedness. 

f)  Issue  letters  of  credit  authorizing  the  holders  thereof  to 
draw  drafts  upon  it  or  its  correspondents  at  sight,  or  upon 
time  not  exceeding  one  year. 

g)  Give  its  bonds  or  obligations  when  moneys,  or  securities 
for  money,  are  borrowed  or  received  on  deposit,  or  for  invest- 
ment. 

2.  Investment:  A  trust  company  may 

Purchase,  invest  in,  sell  stocks,  bonds,  bonds  and  mortgages, 
and  other  securities. 

3.  Agency:  A  trust  company  may  act  as 

a)  Fiscal  agent,  transfer  agent,  registrar  of  the  United 
States,  any  state,  municipality,  body  politic,  or  corporation, 
and  in  such  capacities  may  receive  and  disburse  money,  trans- 
fer, register,  and  countersign  certificates  of  stock,  bonds,  and 
other  evidences  of  indebtedness. 

b)  Attorney  in  fact  for  any  lawful  purpose,  for  any  person 
or  corporation  (foreign  or  domestic). 

c)  Agent. 

d)  Agent  for  married  women  in  respect  to  their  separate 
property. 

4.  Fiduciary:  A  trust  company  may 

Take,  accept,  execute  any  and  all  such  legal  trusts,  duties, 
powers  of  whatever  description,  not  prohibited  by  law,  as  may 


TRUST  COMPANIES  AND  THE  FINANCIAL  SYSTEM    303 

be  granted  to,  confided  in,  conferred  upon,  intrusted  to,  trans- 
ferred to,  vested  in  it  by  any  court  of  competent  jurisdiction 
or  surrogate,  and  may  act  under  the  order  or  appointment  of 
such  court,  as 

a)  Guardian,  receiver,  trustee  of  the  estate  of  any  minor. 

ft)  Depositary  of  moneys  paid  into  court  whether  for  the 
benefit  of  any  minor,  person,  corporation,  party. 

c)  Trustee,  guardian,  receiver,  committee  of  the  estate 
of  any  lunatic,  idiot,  person  of  unsound  mind,  habitual 
drunkard. 

d)  Receiver,  committee  of  the  property  or  estate  of  any 
person  in  insolvency  or  bankruptcy  proceedings. 

e)  Executor  of  or  trustee  under  the  last  will  and  testament, 
or  administrator  with  or  without  the  will  annexed,  of  the  estate 
of  a  deceased  person. 

/)  In  any  other  fiduciary  capacity. 

For  person,  persons,  municipality,  body  politic,  corporation 
(foreign  or  domestic),  or  authority  by  wiU,  grant,  assignment, 
transfer,  or  otherwise,  it  may  act  as 

a)  Executor  or  trustee  under  will  or  deed. 

b)  Trustee  for  married  women  in  respect  to  their  separate 
property. 

c)  Trustee  under  marriage  settlements. 
i)  Trustee  under  separation  agreements. 

e)  Depositary  under  stipulations  between  persons  engaged 
m  Utigation. 

f)  Depositary  in  escrow  of  cash,  securities,  agreements. 

g)  Depositary  under  lease  contracts. 

h)  Depositary  under  syndicate  and  reorganization  agree- 
ments. 

t)  Depositary  or  agent  of  voting  trustees  under  voting 
trusts. 

j)  Trustee  under  mortgages  issued  by  corporations  (foreign 
or  domestic),  municipaUties,  bodies  politic. 

k)  Trustee  under  equipment  trusts. 

And  according  to  the  terms  of,  and  being  accountable  to 
all  persons  in  interest  for  the  faithful  discharge  of  every  such 


304        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

trust,  duty,  or  power  which  it  may  accept,  it  may  receive, 
take,  manage,  hold,  dispose  of,  sell  any  property,  real  or  personal, 
wherever  located,  and  the  rents  and  profits  thereof. 

5.  Safe  keeping:  A  trust  company  may 

Let  out  receptacles  for  the  safe  deposit  of  personal  property. 

Receive  for  safe-keeping  bonds,  mortgages,  jewelry,  plate, 
stocks,  securities,  valuables,  upon  such  terms  and  conditions 
as  it  may  prescribe. 

The  first  two  types  of  operations  engaged  in  by  trust  com- 
panies, namely,  banking  and  investment,  are  in  this  treatise 
discussed  in  other  chapters — banking  in  the  chapters  on  sav- 
ings and  commercial  banking  respectively,  and  investment  in 
connection  with  the  marketing  of  high-grade  securities.*  In 
this  chapter,  therefore,  we  shall  consider  only  the  operations 
listed  above  under  agency,  fiduciary,  and  safe-keeping. 


n.    SERVICES  RENDERED  TO  INDIVIDUALS 

The  trust  company  performs  its  services  for  individuals, 
for  estates,  and  for  corporations.  The  nature  of  the  services 
rendered  to  individuals  may  in  the  main  be  readily  ascer- 
tained by  reference  to  the  powers  of  trust  companies,  as  shown 
in  the  outline  above.  Only  one  of  the  operations  involved 
requires  explanation,  that  of  depositary  in  escrow. 

An  escrow  is  usually  defined  as  "a  deed  placed  by  the 
grantor  in  the  hands  of  a  third  party  to  be  deUvered  to  the 
grantee  upon  the  fulfilment  by  the  latter  of  certain  specified 
conditions."  Mortgages  and  notes  as  well  as  deeds  may,  how- 
ever, be  placed  in  escrow;  and  trust  companies  are  often  made 
depositaries  of  various  articles  of  value  which  are  to  be  held 
for  delivery  under  conditions  similar  to  those  under  an  escrow 
arrangement.  While  not  escrows  in  the  strictly  legal  sense, 
they  amount  practically  to  the  same  thing  and  are  sometimes 
called  "informal"  escrows.  It  is  the  duty  of  the  holder  of  an 
escrow  to  deliver  the  instrument  to  the  grantee  upon  his  per- 

'  See  also  charts  on  pp.  359,  j6o,  and  discussion  on  pp.  725-3a 


TRUST  COMPANIES  AND  THE  FINANCIAL  SYSTEM    305 

fonnance  of  his  part  of  the  contract,  or  to  withhold  the  instru- 
ment in  case  the  contract  is  not  fulfilled. 

An  additional  feature  is  the  acceptance  of  "living  trusts." 
One  of  the  most  interesting  services  performed  for  individuals 
is  not  indicated  in  the  above  grant  of  powers,  that  of  a  "living 
trust."  Under  a  living  trust  a  customer  may  deposit  with  a 
trust  company  funds  or  securities  of  any  kind  and  during  his 
lifetime  may  counsel  with  the  company  regarding  investments 
and  other  estate  matters.  This  enables  the  trust  company  to 
become  famiHar  with  the  client's  wishes  as  to  the  method  of 
handling  his  estate,  so  that  his  policies  may  continue  to  be 
carried  out  after  his  death.  At  the  same  time,  the  individual 
is  reUeved  of  all  details  in  connection  with  the  handling  of  his 
affairs  and  receives  the  benefit  of  much  valuable  information 
and  advice  from  investment  experts. 

III.    SERVICES  PERFORMED  FOR  ESTATES 

For  estates  the  following  services  may  be  enumerated: 
(i)  administrator,  executor,  guardian,  and  conservator; 
(2)  trustee  under  wills;  (3)  receiver  and  assignee;  (4)  depositary 
for  money  and  property  of  estates  under  order  of  the  Probate 
Court;   (5)  depositary  for  alien  property  custodian. 

The  advantages  of  the  trust  company  over  an  individual 
in  acting  as  trustee  of  estates  are  stated  by  one  trust  com- 
pany as  follows: 

It  is  a  fiduciary  organization  manned  by  trained  officers,  experi- 
enced in  the  technique  of  modem  trust  a.nd  agency  duties.  It  is  the 
trustee  for  many  estates  the  property  of  which  requires  manifold 
skill  and  composite  knowledge  to  produce  the  maximum  income 
therefrom.  It  is  a  trustee  with  continuous  existence  and  therefore 
not  subject  to  the  limitations  of  an  individual  and  the  frailties  of 
human  life;  it  is  able  to  give  uninterrupted  service  from  generation  to 
generation.  It  is  a  trustee  that  has  no  family  prejudices  to  bias  its 
judgment.  It  is  a  trustee  that  has  the  financial  ability  to  carry  on 
an  estate  without  embarrassment  to  the  beneficiaries,  while  property 
matters  are  in  an  unsettled  condition.  It  is  a  trustee  that  has  at 
its  command  a  great  many  sources  of  counsel  and  knowledge  in 


3o6         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

regard  to  investments.  It  is  a  trustee  that  does  not  need  to  give 
bond  (for  which  an  estate  or  trust  must  pay),  because  of  its  own 
ample  capital  and  surplus. 

It  is  now  a  common  practice  for  a  trust  company  to  tender 
the  services  of  its  officers  for  the  drawing  of  wills  and  to  act 
as  their  custodian  until  the  death  of  the  testator.  Such  service 
is  usually  performed  without  charge  in  case  the  company  is 
appointed  executor  of  the  estate. 

Trusi  companies  sometimes  manage  insurance  funds.  A 
service  related  to  the  management  of  estates,  that  of  handling 
insurance  funds  for  beneficiaries,  has  of  recent  years  been 
developed  by  trust  companies.  This  is  done  by  means  of 
a  trust  agreement.  The  policies  are  made  payable,  or  are 
assigned,  to  the  trust  company  as  trustee,  and  at  the  death  of 
the  insured  the  company  collects  the  proceeds  of  the  policy, 
of  which  it  has  meantime  been  the  custodian,  and  applies  such 
proceeds  according  to  the  terms  of  the  trust  agreement.  Since 
many  insurance  companies  do  not  write  policies  allowing  stated 
payments  to  be  made  to  beneficiaries,  this  plan  furnishes  an 
opportunity  for  the  insured  to  have  his  insurance  paid  in  any 
manner  desired.  Trust  agreements  are  sometimes  made  so 
that  the  beneficiary  may  be  paid  stated  annuities  out  of  the 
proceeds  of  life  insurance.  This  arrangement  is  especially 
valuable  where  a  man  is  not  able  to  carry  an  amount  of  insur- 
ance such  that  the  income  alone  will  support  his  family.  For 
instance,  one  of  the  leading  companies  of  the  central  states 
advertises  that  with  $10,000  of  insurance  it  is  able  to  pay  an 
armuity  of  $500  for  forty. years. 

IV.    TRUST  COMPANIES  AND  CORPORATION 
FINANCE 

Among  the  services  of  trust  companies  none  are  more 
important  than  those  rendered  to  corporate  enterprise.    A 
corporation  is  dependent  upon  the  trust  company  alike  in  con- 
nection with  the  raising  of  fixed  capital,  with  the  management  of 
certain  of  its  financial  affairs  as  a  going  concern,  and  with  safe- 


TRUST  COMPANIES  AND  THE  FINANCIAL  SYSTEM     307 

guarding  the  interests  of  both  creditors  and  shareholders  in  the 
event  of  insolvency  and  financial  reorganization.  We  shall 
find,  moreover,  that  the  investors  in  corporate  securities  are 
also  largely  dependent  upon  the  performance  of  certain  trust 
company  operations.  At  this  point  therefore  the  analysis 
supplements  that  given  in  the  chapters  dealing  with  the 
marketing  of  securities. 

The  principal  ways  in  which  the  trust  company  is  of  service 
in  connection  with  corporate  financing  are  as  foUows:  (i)  as 
trustee  under  mortgages  and  indentures,  securing  bond  and 
note  issues;  (2)  as  trustee  under  equipment  trust  agreements; 
(3)  as  transfer  agent;  (4)  as  registrar  of  securities;  (5)  as 
depositary  imder  reorganization  agreements;  (6)  as  fiscal  agent. 

i)  Tmstee  under  mortgages.  Under  the  system  of  corporate 
finance,  bonds  of  small  denomination  are  sold,  as  we  have  seen, 
to  the  general  investing  public  on  the  security  of  a  mortgage, 
which  recites  the  conditions  under  which  foreclosure  proceed- 
ings may  be  started  and  states  what  property  is  to  be  turned 
over  to  the  bondholders  in  case  of  insolvency.  The  appoint- 
ment of  a  reliable  trustee  for  the  protection  of  the  mortgage  is 
accordingly  indispensable  to  the  successful  operation  of  the 
system  of  issuing  securities. 

Before  a  trust  company  accepts  a  mortgage  trust,  great  care 
is  taken  to  ascertain  the  correctness  of  statements  that  are 
made  and  the  legality  of  the  mortgage.  It  is  customary  to 
require  an  opinion  from  a  counsel  of  the  corporation  issuing  the 
mortgage  that  the  document  has  been  drawn  up  in  proper 
form  and  that  it  fulfils  the  requirements  of  the  state  in  which 
the  property  to  be  mortgaged  is  situated.  It  is  also  customary 
to  submit  a  draft  of  the  proposed  mortgage  and  bonds  to  the 
trust  company  for  inspection,  in  cases  where  the  bonds  are 
passed  upon  by  the  legal  counselors  of  the  trust  company. 
When  the  preliminary  arrangements  have  been  completed, 
the  mortgage  is  executed  in  duplicate  and  acknowledgment  of 
the  acceptance  of  the  trust  is  made  by  the  trust  company. 

A  closely  related  service  is  in  connection  with  the  engraving 
and  issuing  of  the  bonds.     Bonds  are  usually  engraved  by 


3o8         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

responsible  engraving  companies  from  plates  especially  pre- 
pared for  the  purpose.  Precautions  are  taken  by  the  trustee 
to  prevent  any  impressions  being  lost  or  stolen;  and  sometimes 
the  engravers  are  required  to  give  security  against  loss  resulting 
from  negligence  on  their  part.  After  the  bonds  have  been 
printed,  they  are  sealed  with  the  corporate  seal,  attested  by  the 
officers  of  the  issuing  corporation,  and  then  sent  to  the  trust 
company,  which  certifies  and  delivers  them  as  provided  in 
the  mortgage.  Before  certification,  however,  each  bond  is 
examined  to  insure  its  being  in  proper  form. 

Where  the  mortgage  provides  for  a  sinking  fund  for  a 
gradual  retirement  of  the  bonds  or  for  their  payment  at 
maturity,  it  is  the  duty  of  the  trust  company  to  see  that  such 
sinking-fund  provisions  are  complied  with.  It  thus  acts  as  a 
sort  of  enforcing  agent  for  the  bondholders. 

In  the  case  of  "collateral  trust"  bonds,*  the  collateral  is 
held  by  the  trust  company  for  the  protection  of  the  bond- 
holders. Sometimes  the  terms  of  the  mortgage  provide  that 
the  issuing  corporation  may  make  a  substitution  of  collateral, 
in  which  case  it  is  the  duty  of  the  trustee  to  make  sure  that 
the  substituted  securities  are  fully  equal  in  value  to  the  original 
ones. 

2)  Trustee  of  equipment  trusts.  Equipment  trusts  arise 
from  a  special  type  of  financial  borrowing — that  by  railroad 
companies  for  the  purpose  of  acquiring  new  rolling  stock.  As  a 
means  of  making  securities  attractive  to  buyers,  an  arrangement 
is  effected  with  the  builder  of  railway  cars,  whereby  a  partial 
payment  may  be  made  by  the  railroad  company  upon  the 
delivery  of  the  cars  and  notes  given  for  the  remainder.  These 
notes,  which  usually  mature  serially  over  a  period  of  years,  are 
sold  to  investors.  The  title  to  the  cars  is  vested  in  a  trust 
company  as  trustee  and  the  railroad  company  leases  the  cars 
from  this  trustee.  The  rental  received  by  the  trustee  from 
the  railroad  is  sufficient  in  amount  to  meet  the  annual  interest 
on  the  notes  and  to  retire  a  certain  number  of  them  each  year. 
In  this  way  the  railroad  is  enabled  to  borrow  the  funds  with 

•See  p.  IS7  above. 


TRUST  COMPANIES  AND  THE  FINANCIAL  SYSTEM      309 

wliich  to  purchase  equipment  at  fairly  low  rates  of  interest 
and  to  pay  off  the  obligation  during  the  life  of  the  rolling  stock. 

3)  Transfer  agent.  Trust  companies  are  usually  chosen  to 
act  as  agents  for  transferring  the  ownership  of  corporate 
securities.  This  function  may  involve  merely  the  transfer  of 
existing  shares  from  one  holder  to  another;  or  it  may  involve 
the  substitution  of  a  new  issue  for  an  old ;  or  of  an  issue  of  bonds 
for  an  issue  of  stock.  As  an  instance  of  the  latter,  if  a  railroad 
company  should  decide  to  call  in  some  of  its  outstanding 
securities  and  replace  them  by  an  issue  of  a  different  typt,  a 
trust  company  would  be  chosen  to  receive  the  old  bonds  from 
their  holders,  issue  receipts  for  them,  and  later  issue  the  new 
securities  to  the  owners  of  these  receipts.  If  money  is  to  be 
paid  on  either  side,  it  is  distributed  by  the  trust  company, 
which  thus  acts  as  custodian  of  the  interests  of  both  the  public 
and  the  corporation. 

The  services  of  a  transfer  agent  have  been  described  as 
follows:^ 

The  duty  of  the  transfer  agent  is  to  act  for  the  issuing  corpora- 
tion in  the  matter  of  making  transfers  of  the  ownership  of  its  stock 
from  one  holder  to  another.  This  involves  the  passing  upon  the 
regularity  and  legality  of  the  assignment  of  title;  the  noting  of  the 
transaction  upon  the  transfer  books  of  the  corporation;  the  cancel- 
lation of  the  old  certificates  and  the  execution  and  delivery  of  new 
certificates.  Incidentally  it  involves  the  furnishing  to  the  corporation 
of  a  certified  list  of  the  stockholders  whenever  the  books  are  closed 
for  the  payment  of  dividends,  and  at  other  times  as  demanded. 

The  performance  of  these  duties  requires  that  the  transfer  agent 
be  the  custodian  of  the  stock  books  and  the  seal  of  the  issuing  cor- 
poration and  of  a  supply  of  blank  certificates.  The  certificates, 
bound  in  book  form  so  that  each  certificate  and  its  stub  form  one 
page,  and  numbered  consecutively,  are  before  delivery  to  the  trans- 
fer agent  signed  by  the  proper  ofiicers  of  the  corporation.  The  face 
of  the  certificate  usually  contains  the  provision  that  it  is  not  valid 
unless  countersigned  by  the  transfer  agent.  On  its  back  is  usually 
printed  an  assignment  of  the  stock  and  an  irrevocable  power  of 
attorney 

'  Clay  Herrick,  Trust  Companies,  pp.  413-16. 


3IO        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Before  making  delivery  of  a  certificate,  the  transfer  agent  dates 
it,  fills  in  the  name  of  the  new  holder  and  the  number  of  shares 
represented,  affixes  the  seal  of  thC  issuing  corporation,  and  attaches 
the  proper  signature  to  the  transfer  agent's  certificate. 

The  practical  work  of  transferring  stock  requires  a  high  degree 
of  intelligence  and  care  and  a  thorough  knowledge  of  the  law  govern- 
ing such  transfers.  The  risks  involved,  aside  from  possible  clerical 
mistakes,  errors  in  bookkeeping,  dishonesty  or  gross  carelessness  on 
the  part  of  the  employees  who  actually  do  the  work,  include  mis- 
takes of  law  or  of  fact  in  making  transfers  on  forged  indorsements* 
or  on  insufficient  authority,  or  in  violation  of  law,  especially  in  cases 
of  certificates  held  by  persons  as  trustees  for  others.  Certificates 
indorsed  in  blank  are  often  presented  for  transfer  by  persons  other 
than  the  holders  of  record.  The  transfer  agent  must  know  the 
signatures  of  stockholders  or  otherwise  identify  them  beyond  ques- 
tion. Where  stock  is  held  in  fiduciary  capacities,  the  agent  must 
know  the  terms  and  powers  under  which  it  is  held.  When  a  cer- 
tificate is  presented  for  transfer,  the  transfer  clerk  should  know  that 
the  certificate  itself  and  the  power  of  attorney  accompanying  it  are 
genuine;  that  the  transferer  is  legally  competent  to  make  the 
transfer;  that  no  notice  has  been  given  the  company  of  any  out- 
standing claims  against  the  stock;  that,  in  the  absence  of  direct 
notice,  there  is  no  implied  notice  of  claims,  such  as  the  certificate 
itself  may  give  when  standing  in  the  name  of  a  trustee,. 

On  the  subject  of  the  exact  Habilities  assumed  by  the  transfer 
agent  in  agreeing  to  perform  these  services,  there  is  a  considerable 
difference  of  opinion,  which  is  readily  accounted  for  by  the  fact 
that  there  is  no  statute  law  covering  the  case,  and  very  little  law  in 
the  shape  of  court  decisions.  While  the  office  is  sometimes  under- 
taken under  special  contract  which  details  the  liabilities  to  the  issuing 
corporation,  the  more  common  method  of  appointment  is  by  a  mere 
resolution  of  the  directors  of  the  issuing  corporation  appointing  the 
Blank  Trust  Company  as  the  transfer  agent  of  its  stock,  and  the 
acceptance  of  the  appointment  by  the  latter.  This  method  assumes 
that  the  duties  and  liabilities  of  the  position  are  so  well  known  as  to 
require  no  definition;  an  assumption  which  is  justified  so  far  as 
routine  duties  are  concerned,  but  which  as  to  liabilities  seems  incon- 
sistent with  the  divergent  opinions  held  by  ofiicets  uf  banks  and 
trust  companies  which  act  as  transfer  agents.  The  difference  of 
opinion  does  not  concern  what  the  trust  company  accepting  an 


TRUST  COMPANIES  AND  THE  FINANCIAL  SYSTEM      311 

appointment  expects  and  intends  to  undertake,  but  has  reference  to 
possible  implied  and  incidental  obligations  which  it  does  not  intend 
to  assume,  but  for  which,  in  the  opinion  of  some  writers,  the  courts 
may  hold  it  responsible.  "It  is  well  understood  in  banking  and 
trust  circles  that  the  transfer  agent  undertakes  to  say  to  the  pur- 
chaser of  the  stock  which  it  has  coimtersigned  no  more  nor  less  than 
that  such  stock  is  a  genuine  portion  of  the  capital  stock  of  the  issuing 
company,  that  the  said  company  has  been  duly  authorized  to  do 
business  by  the  secretary  of  the  state  in  which  the  company  is  incor- 
porated, and  that  the  signatures  of  the  officers  to  the  certificates  of 
stock  are  genuine. 

4)  Registrar  of  securities.  The  purpose  of  having  an  inde- 
pendent registrar  of  stock,  or  of  registered  bonds,  may  best  be 
disclosed  by  reference  to  the  origin  of  the  practice.  In  1863 
occurred  the  notorious  Schuyler  frauds,  in  which  Robert 
Schuyler,  who  was  president  and  also  transfer  agent  of  the 
New  York  &  New  Haven  Railroad  Company,  apparently 
over-issued  the  stock  of  his  company.  Since  such  practices,  if 
unchecked,  would  soon  bring  the  entire  securities  business  into 
disrepute,  the  New  York  Stock  Exchange,  in  order  to  prevent 
a  recurrence  of  such  frauds,  adopted  a  rule  in  January,  1869, 
which  required  all  active  stocks  to  be  registered  by  an  agency 
approved  by  it.  The  duties  of  a  registrar  are  stated  by  Herrick 
as  follows:^ 

The  duty  of  the  registrar  of  stock  is  to  register,  or  record  the 
issue  of,  certificates  of  stock  after  they  have  been  issued  bj.  the 
transfer  agent,  for  the  purpose  of  preventing  an  over-issue  of  such 
stock.  Before  assuming  its  duties  the  registrar  must  be  furnished 
with  authentic  information  as  to  the  total  amount  of  stock  author- 
ized to  be  issued,  if  none  has  been  issued ;  or  as  to  the  total  amount  of 
stock  authorized  to  be  issued  and  the  amount  outstanding,  if  part 
or  all  has  been  issued.  After  the  total  amoimt  of  shares  authorized 
to  be  issued  has  been  registered,  new  certificates  are  not  registered 
except  upon  the  cancellation  of  outstanding  certificates  for  the  same 
number  of  shares. 

In  practice  the  registrar  keeps  a  registry  list,  and  as  stock  is 
transferred  by  the  company  or  its  transfer  agent  it  receives  in  each 

'  Herrick,  Trust  Companies,  pp.  425-26. 


312  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

case  the  old  certificate  as  surrendered  and  the  new  certificate  as  pre- 
pared to  take  its  place,  it  compares  the  two,  it  notes  upon  its  registry 
list  the  surrender  and  cancellation  of  the  old  and  the  issue  of  the 
new  in  substitution,  and  it  thereupon  identifies  the  new  certificate 
by  its  signature  upon  its  face  as  a  part  of  a  stated  authorized 
issue. 

The  Uabilities  involved  are  at  the  present  purely  a  matter  of 
opinion,  as  there  is  practically  no  law  on  the  subject. 

It  is  almost  a  universal  practice  for  a  corporation  to  select 
as  registrar  a  different  trust  company  from  the  one  which 
serves  as  transfer  agent.  The  function  of  the  registrar  is  to 
operate  as  a  check  upon  any  error  or  irregularity;  and  with 
a  single  institution  acting  both  as  registrar  and  as  transfer 
agent  there  is  obviously  a  greater  possibility  that  an  over-issue 
of  securities  will  not  be  detected.  Where  registrar  and  transfer 
agent  are  separate  institutions,  collusion  would  be  necessary  to 
permit  an  over-issue;  the  separate  agents  in  a  sense  act  as 
checks  upon  each  other. 

S)  Depositary  under  reorganization  agreements.  In  case  of 
the  default  of  interest  on  bonds,  a  committee  is  usually  formed 
to  represent  the  bondholders.  This  committee  formulates  a 
plan  of  financial  reorganization;  and  pending  the  reorganiza- 
tion the  committee  calls  for  the  deposit  of  the  bonds,  the 
interest  on  which  has  been  defaulted,  with  some  trust  com- 
pany, which  is  designated  as  depositary.  In  exchange  for 
thesC  securities  the  trust  company  gives  temporary  receipts, 
good  for  a  limited  number  of  days  only.  Since  the  process  of 
reorganization  usually  requires  several  months — if  not  years — 
these  temporary  receipts  are  later  exchanged  for  engraved 
certificates  of  deposit  which  are  in  transferable  form  and 
available  for  trading  on  the  stock  exchange  like  regular  bonds 
and  shares.  These  certificates  specify  the  kind  and  value  of 
the  security  deposited  and  the  terms  under  which  the  certificate 
is  issued,  and  state  that  the  trust  company  holds  the  securities 
on  terms  agreed  to  by  the  owners  thereof. 

Financial  reorganization  is  also  necessary  whenever  a  con- 
solidation of  several  corporations  into  a  single  company  is 


TKUST  COMPANIES  AND  THE  FINANCIAL  SYSTEM      313 

effected.  The  trust  company  is  here  also  called  upon  to  act  as 
depositary  during  the  process  of  financial  reorganization. 

The  trust  company  may  also  act  as  assignee  and  receiver 
when  a  firm  or  corporation  becomes  insolvent.  The  appoint- 
ment of  a  trustee  as  assignee  may  be  made  either  at  the  request 
of  the  owners  of  the  business,  who  wish  to  protect  their  property, 
or  at  the  instance  of  creditors,  who  wish  to  safeguard  their 
interests.  The  property  may  be  turned  over  to  the  trust  com- 
pany by  an  assignment,  in  which  case  the  assignee's  duties 
usually  consist  of  collecting  the  debts  and  requiring  creditors 
to  prove  their  claims. 

The  trust  company  acts  as  receiver  imder  appointment  by 
a  court,  and  the  object  is  generally  to  tide  an  embarrassed 
enterprise  over  a  period  of  difficulty.  Since  the  receiver  is 
merely  an  officer  of  the  court,  it  has  no  powers  other  than 
those  conferred  upon  it  by  the  court.  The  court  authorizes 
the  issue  of  receiver  certificates  to  provide  funds  for  the  pur- 
chase of  equipment,  the  maintenance  of  the  property,  and  the 
conduct  of  the  business.  Such  certificates  may  be  made  a 
first  hen  on  all  assets,  even  taking  precedence  over  mortgages 
and  other  secured  obligations.  In  this  way  the  receiver  is 
enabled  to  secure  the  necessary  capital  with  which  to  place 
the  company  upon  a  satisfactory  financial  footing. 

6)  Fiscal  agency.  As  fiscal  agent  for  a  corporation,  the 
company  takes  either  general  or  special  charge  of  the  finances 
of  the  corporation,  according  to  the  terms  of  the  agreement. 
It  may  assume  the  role  of  treasurer,  having  charge  of  all  receipts 
and  disbursements;  or  it  may  merely  act  as  agent  for  the 
payment  of  coupons,  interest,  and  dividends,  either  under 
the  terms  of  a  mortgage  or  independently  of  any  trustee- 
ship. 

A  certain  trust  company  states  that  as  fiscal  agent  it  will 
assume  custody  of  securities,  give  notice  of  maturities,  and 
collect  coupons  as  they  come  due;  take  custody  of  title  deeds, 
insurance  poUcies,  and  other  documents,  keeping  all  necessary 
records  incident  thereto;  examine  periodically  the  condition  of 
corporations  whose  securities  are  held  and  advise  with  the 


314         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

proper  officers  of  the  organization  with  respect  to  the  replace- 
ment of  securities  that  are  becoming  less  valuable;  examine 
periodically  real  estate  when  under  lease,  especially  where  the 
lease  requires  the  payment  of  taxes  and  observance  of  obliga- 
tions by  tenants  in  the  matter  of  repairs  and  replacements; 
keep  separate  general  books  under  such  accounts  as  the 
corporation  may  direct. 

One  trust  company  suggests  that — 

The  taanagement  of  business  corporations  may  well  consider 
the  advantage  of  having  general  salary  accoimts,  dividend,  interest, 
investment,  bills  payable,  profit  and  loss,  and  other  general  and 
controlling  accounts  kept  separate  from  the  accoimts  of  the  operat- 
ing office  and  from  the  observation  of  employees  therein. 

In  many  cases  the  volume  of  such  general  office  business,  even 
inclusive  of  records  of  directors'  and  stockholders'  meetings,  would 
not  warrant  the  considerable  expense  of  a  suitable  separate  corporate 
office.  In  such  cases  the  fiscal  agency  service  of  this  company  gives 
all  the  benefits  of  such  an  office  at  a  nominal  cost. 

As  agent  for  the  payment  of  interest,  dividends,  etc.,  the 
trust  company  receives  from  the  corporation  in  advance  of  the 
date  when  interest  or  dividends  are  due,  a  sum  of  money  equal 
to  the  total  amount  to  be  paid.  In  the  case  of  coupon  bonds 
the  interest  is  held  subject  to  the  call  of  the  owner,  while  in 
the  case  of  dividends  on  stock  and  interest  on  registered  bonds 
a  check  is  sent  to  the  owners  whose  names  appear  on  the 
register  held  by  the  registrar. 

Although  coupons  are  made  payable  to  bearer,  a  record  is 
made  of  the  names  of  the  persons  who  present  them  for  pay- 
ment at  the  counter  of  the  trust  company,  or  of  the  names  of 
the  banks  presenting  them  on  behalf  of  their  customers.  The 
trust  company  keeps  a  record  of  the  numbers  of  the  bonds 
from  which  the  coupons  are  cut.  When  paid  the  coupons  are 
canceled  by  the  punching  of  holes  in  them;  and  they  are  then 
filed  away  by  bond  numbers,  to  be  returned  at  intervals,  usually 
monthly,  to  the  issuing  corporation. 

Trust  companies  also  act  as  fiscal  agents  for  educational  and 
charitable  institutions,  clubs,  lodges,  etc.    The  nature  and  sig- 


TRUST  COMPANIES  AND  THE  FINANCIAL  SYSTEM      315 

nificance  of  such  service  is  stated  by  one  trust  company  in  the 

following  language: 

The  functions  of  educational,  charitable,  and  similar  institutions 
continue  lui interruptedly  from  generation  to  generation.  Execu- 
tive officers,  serving  for  the  most  part  without  compensation,  change 
frequently,  involving  a  transfer  of  records  and  securities,  always 
with  the  danger  of  loss  of  records  and  of  inadequate  attention  to  the 
changing  values  of  securities.  It  is  therefore  highly  desirable  to 
secure  continuity  of  service,  permanent  housing  of  important  records, 
and  prompt  and  efficient  handling  of  the  routine  work  of  the  organi- 
zation. 

The  Trust  Company  wiU  provide  such  secretarial  and  steno- 
graphic service  as  may  be  required  for  giving  necessary  notices 
of  meetings;  will  transcribe  minutes  and  resolutions  acciu-ately  and 
uniformly  into  the  permanent  records;  wiU  give  notice  of  all  dues 
and  other  obligations  payable  to  the  organization;  will  receive  and 
acknowledge  all  payments  made  for  the  organization's  accoimt,  and 
deposit  the  same,  reporting  at  regular  and  special  meetings  the 
collections  made  and  the  items  in  default;  will  draw  checks  for 
authorized  amoimts  covering  all  items  payable,  including  annuities, 
interest,  salaries,  and  current  accounts,  and  will  mail  the  same. 

Oftentimes  the  secretary  and  the  treasurer  of  an  organization 
are  persons  who  are  absorbed  in  the  duties  of  their  own  calling  or 
are  frequently  absent  from  home.  It  is  highly  desirable  that  the 
responsibilities  of  these  offices  be  in  hands  where  routine  will  be 
promptly  and  efficiently  handled. 

In  many  cases  the  treasurer  is  allowed  a  fund  for  clerical  assist- 
ance. Such  a  fund,  applied  to  secure  fiscal  agency  service,  will 
relieve  the  treasiKer  of  responsibility  of  oversight  and  will  guarantee 
the  accuracy  and  integrity  of  the  records. 

It  is  certainly  an  advantage  and  a  matter  of  prestige  to  be  able 
to  obtain  in  the  handling  of  the  securities,  accounts,  properties,  and 
investments  of  any  organization  the  degree  of  accuracy,  the  absolute 
responsibility,  and  the  safeguards  of  state  supervision  which  are  to 
be  found  in  a  trust  company  alone.  Whatever  the  high  character 
or  ability  of  an  individual,  it  is  out  of  the  question  that  he  can  bring 
to  bear  on  such  duties  all  of  the  highly  specialized  forces  of  a  large 
banking  institution. 


3i6         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

V.    THE  TRUST  COMPANY  AS  CUSTODIAN  OF 
SECURITIES 

WMle  trust  companies  are  not  the  only  financial  institu- 
tions that  maintain  safety-deposit  vaults  and  boxes  for  the 
safe-keeping  of  valuables  and  securities,  they  have  from  the 
beginning  made  a  specialty  of  such  business,  trust  company 
legislation  having  recognized  it  as  an  important  feature  of  trust 
company  work.  The  law  of  New  York,  for  example,  author- 
izes trust  companies — 

To  receive,  on  terms  and  conditions  to  be  prescribed  by  the  com- 
pany, upon  deposit  for  safe-keeping,  bonds,  mortgages,  jewelry, 
plate,  stocks,  securities  and  valuable  papers  of  any  kind,  and  other 
personal  property,  for  hire,  and  to  let  out  receptacles  for  safe  deposit 
of  personal  property. 

Some  of  the  larger  companies  have  gone  much  farther  than 
merely  to  maintain  safety-deposit  boxes.  The  growth  of  large 
fortunes,  which  under  modern  conditions  are  mainly  invested 
in  corporate  securities,  has  opened  up  a  new  field  of  work  for 
the  trust  company — that  of  custodian  of  the  securities  and 
papers  deposited  with  them  by  individuals.  The  amount  of 
detail  that  must  be  looked  after  if  the  owner  of  a  large  volume 
of  securities  is  to  avoid  losses  and  make  the  most  of  oppor- 
tunities is  so  great  that  a  responsible  financial  secretary  and 
adviser  is  practically  indispensable.  In  this  capacity  trust 
companies  render  a  variety  of  important  services,  outlined  by 
a  large  New  York  trust  company  in  the  following  language: 

A.     AVAILABrUTY 

When  securities  are  locked  up  in  a  safe  deposit  box,  they  are 
not  available  to  the  owner  in  case  of  sickness  or  absence  from  home. 
From  this  cause  serious  embarrassment  often  results,  for,  while  a 
person  may  be  entirely  solvent,  his  securities  may  not  be  available 
in  time  of  need,  merely  because  for  some  reason  he  is  unable  to  go 
to  his  safe  deposit  box  in  person. 

On  the  other  hand,  when  securities  are  held  in  safe-keeping,  they 
are  alway  available  to  the  depositor  at  any  time.  By  letter,  telegraph, 
or  cable,  he  may  direct  their  delivery  or  sale,  and  may  withdraw 


TRUST  COMPANIES  AND  THE  FINANCIAL  SYSTEM      317 

them  at  any  time  to  be  used  as  collateral  to  loans.  No  matter 
where  the  depositor  may  be,  his  securities  are  always  subject  to  his 
control  and  direction. 

In  order  that  our  clients  readily  may  direct  the  sale  or  delivery 
of  stocks  or  registered  bonds,  the  securities  should  be  endorsed  in 
blank  with  the  signatures  properly  witnessed  or  guaranteed. 

Where  prolonged  absence  is  contemplated,  it  is  especially  desirable 
to  have  the  stocks  or  registered  bonds  stand  in  the  name  of  a  nominee  of 
the  trust  company.  This  is  especially  the  case  where  the  securities 
stand  in  the  names  of  women,  whether  married  or  unmarried,  as  a 
certificate  in  a  woman's  name  is  not  a  "good  delivery"  in  accordance 
with  the  rules  of  the  New  York  Stock  Exchange,  and  must  be  trans- 
ferred to  the  purchaser's  name  or  to  the  name  of  one  of  our  clerks 
before  delivery  can  be  made.  This  transfer  necessitates  the  payment 
of  a  double  transfer  tax. 

A  further  advantage  in  having  securities  stand  in  the  name  of 
a  nominee  is  that  it  makes  it  possible  to  sell  a  portion  of  the  stock 
represented  by  a  certificate  and  still  have  the  remainder  in  negotiable 
form.  For  instance,  if  a  depositor  has  a  certificate  for  100  shares  of 
stock  registered  in  his  name  and  endorsed  in  blank,  and  while  absent 
from  the  city  desires  to  sell  only  50  shares,  the  loo-share  certificate 
must  be  split  into  two  50-share  certificates,  one  of  which  may  be 
registered  in  the  name  of  the  pending  purchaser,  but  the  other 
would  stand  in  the  name  of  the  depositor  and  would  necessarily  not 
be  endorsed  and  therefore  would  not  be  negotiable.  The  remaining 
50  shares,  therefore,  would  not  be  available  for  sale  until  endorsed  by 
the  depositor  for  that  purpose.  If,  however,  the  certificate  stood  in 
the  name  of  a  nominee,  the  new  certificate  upon  its  receipt  from 
transfer  would  be  immediately  endorsed  by  the  nominee  in  blank, 
and  wovdd  be  ready  for  immediate  sale  upon  proper  instructions 
from  the  depositor. 

The  Trust  Company  is  at  all  times  responsible  for  the  acts  of 
its  nominees,  and  requires  them  to  file  written  instruments  with  the 
Company,  declaring  that  the  nominee  has  no  ownership  in  the 
certificates  standing  in  his  name  for  that  purpose,  thus  insuring  that 
no  claim  of  ownership  may  be  made  by  the  executors  or  personal 
representatives  of  a  deceased  nominee.  -  , 

The  Company  makes  no  charges  to  its  depositors  for  purchasing, 
selling,  or  delivering  securities  for  their  account.  Depositors,  if  they 
desire,  may  direct  purchases  or  sales  through  their  own  brokerage 


3l8         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

houses,  requesting  their  brokers  to  receive  or  deliver  the  securities 
at  this  office.  At  the  same  time  instructions  should  be  given  to  this 
Company  to  receive  and  pay  for  the  securities  purchased,  or  to 
deliver  and  receive  payment  for  the  securities  sold,  and  to  charge 
or  credit  the  depositor's  account. 

Orders  may  also  be  placed  directly  with  the  Company,  which 
will  effect  the  purchase  or  sale  of  securities  through  brokers. 

Whether  the  order  is  placed  directly  through  the  broker  or 
through  the  medium  of  the  Trust  Company,  the  broker's  commission 
is  (of  course)  added  to  the  purchase  price  or  deducted  from  the  pro- 
ceeds of  the  sale,  but  the  Trust  Company  makes  no  charge  for  its 
services.  In  order  to  insure  the  genuineness  of  all  orders  and  to 
protect  our  depositors  against  fraud,  their  signatures  are  filed  with 
the  Trust  Company,  and  are  compared  with  all  written  instructions. 

It  is  advisable  for  our.  depositors  to  arrange  secret  code  signa- 
tures known  only  to  the  depositors  and  the  officers  of  this  Company, 
which  will  identify  all  instructions  sent  by  cable  or  telegraph.  If 
desired,  secret  code  words  may  be  agreed  upon  to  cover  any  specific 
transaction  concerning  which  the  depositors  may  desire  to  give 
nstructions,  thus  sa\dng  the  expense  of  long  me^ages. 

Persons  traveling  will  find  it  very  economical  to  make  use  of  the 
public  codes,  such  as  Lieber's  code  and  the  Western  Union  code, 
which  are  especially  adapted  for  general  communications,  and  Hart- 
field's  New  Wall  Street  code  which  is  expressly  designed  to  cover  all 
transactions  in  securities.  One  or  the  other  of  these  codes  may  be 
foimd  at  the  offices  of  all  our  correspondents  and  very  generally  in 
any  telegraph  office  or  large  banking  house. 

B.    Routine  Care 
I.  Collection  of  principal  and  income: 

a)  Collection  of  principal  of  maturing  bonds:  The  principal  of 
bonds  as  they  mature  is  collected  and  the  proceeds  either  remitted 
to  the  depositor  or  credited  to  his  account,  under  advice.  Notice 
of  principal  of  bonds  becoming  due  and  payable  is  given  a  month 
in  advance  in  order  to  allow  the  depositor  to  arrange  for  reinvest- 
ment without  the  loss  of  interest. 

b)  Collection  of  bond  interest:  Coupons  upon  bonds  are  detached 
and  deposited  for  collection  when  due,  the  proceeds  being  either 
remitted  to  the  depositor  or  credited  to  his  account,  under  advice. 

c)  Collection  of  dividends:  Where  the  stock  stands  in  the  name 
of  a  depositor,  in  order  that  the  Trust  Company  may  receive  the 


TRUST  COMPANIES  AND  THE  FINANCIAL  SYSTEM      319 

dividends  as  they  are  paid,  the  depositor  must  sign  a  "dividend 
order."  Where  stocks  are  held  in  our  care,  it  is  recommended  that 
the  dividends  be  made  payable  to  this  Company,  for  account  of  the 
customer,  in  order  that  it  may  be  assured  that  the  dividends  are 
received.  Failure  to  receive  a  dividend  when  due  causes  an  immedi- 
ate investigation,  the  depositor  being  notified  in  case  the  dividend 
is  passed.  Similarly,  the  depositor  is  notified  in  case  the  dividend 
is  either  increased  or  reduced. 

2.  Preparation  of  certificates  required  under  the  Federal  In- 
come Tax  Law  preliminary  to  the  collection  of  coupons,  registered 
interest,  pr  dividends:  The  Federal  Income  Tax  Law  surrounds  the 
collection  of  income  with  considerable  detail  more  or  less  vexing  to 
the  investment  holder.  This  detail  the  Trust  Company  is  pre- 
pared to  assimie  imder  an  agency  appointment,  and  thereafter  such 
information  as  may  be  required  by  the  Federal  Income  Tax  Law 
incident  to  the  collection  of  the  income  of  its  depositors  is  prepared 
and  submitted  by  the  Trust  Company  without  further  action  of  its 
depositors. 

3.  Statements: 

Depositors  receive  periodically,  at  such  times  as  they  may 
request,  statements  of  securities  which  they  have  deposited  in  safe 
keeping,  showing 

a)  The  amount  of  each  security 

b)  Its  description 
•     c)  Its  due  date 

d)  Dates  on  which  interest  or  dividends  are  paid  and  the  income 
rettim 

C.    Supervision  of  Deposited  Securities 

The  average  individual  is  kept  informed  concerning  his  holdings 
only  through  his  own  efforts.  Unless  he  personally  keeps  constantly 
in  touch  with  the  information  published  from  time  to  time  relative 
to  his  securities,  he  may  lose  many  opportunities  either  to  act  to  his 
advantage  or  to  save  himself  from  possible  loss.    For  instance: 

a)  His  bonds  may  be  called  for  payment  either  at  the  option 
of  the  issuing  company  or  through  the  operation  of  some  sinking 
fund.  After  the  date  on  which  a  bond  i&  called  for  payment,  interest 
ceases.  If  the  holder's  attention  is  not  called  to  this  he  loses  the 
interest  which  he  would  have  received  had  his  money  been  invested 
immediately. 


320         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

b)  His  bonds  may  have  the  valuable  right  of  being  converted 
into  stock  on  or  before  a  certain  date,  upon  the  expiration  of  which 
the  privilege  is  lost. 

c)  He  may  have  the  right  to  subscribe  to  new  issues  of  stocks  or 
bonds.  Generally,  this  privilege  is  evidenced  by  a  certificate,  which 
is  commonly  known  as  "a  right,"  which  entitles  the  holder  to  sub- 
scribe to  stocks  or  bonds  upon  pajdng  a  certain  siun  not  later  than  a 
certain  date,  after  which  the  privilege  ceases. 

d)  In  time  of  business  depression,  committees  are  often  formed 
for  the  protection  of  securities  and  may  require  their  immediate 
deposit.  Committees  usually  fix  a  certain  date  on  which  securities 
must  be  deposited;  after  this  date  a  penalty  attaches.  Further, 
committees  sometimes  protect  only  the  securities  deposited  with 
them,  and  the  non-co-operating  security  holder,  especially  in  the 
case  of  stocks,  may  not  receive  substantial  advantages  which  might 
be  gained  by  acting  with  the  committee. 

e)  Receivers  may  be  appointed  for  property  in  which  he  is 
interested.  This  may  make  it  advisable  to  dispose  of  the  holdings 
immediately,  before  greater  loss  is  incurred. 

/)  Notice  of  opportunity  to  sell  bonds  to  sinking  funds.  We 
endeavor  to  keep  our  depositors  in  touch  with  these  opportunities, 
as  they  often  afford  the  best  opportunity  of  disposing  of  securities 
which  have  a  narrow  market. 

In  addition  to  the  above  services,  which  are  rendered  auto- 
matically but  only  at  the  express  request  of  our  depositors,  periodical 
examinations  of  their  holdings  are  made  by  investment  experts 
with  a  view  to  determine  whether  it  seems  advisable  to  reconunend 
either  a  change  in  their  securities  because  of  new  conditions  which 
have  arisen,  or  in  order  to  secure  a  more  balanced  and  conservative 
investment. 

D.    Additional  Services  Rendered  to  Depositors 
The  services  already  enumerated  are  those  directly  connected 
with  the  care  and  supervision  of  securities,  but  there  are  many  other 
matters  which  we  are  pleased  to  attend  to  when  requested,  such  as 
I.  Payment  of: 

Taxes  on  real  estate  and  personal  property 

Interest  on  bonds,  mortgages,  and  bank  loans 

Premiums  on  life  and  fire  insurance  policies 

Rent  of  houses  or  apartments  o 

Storage  charges 

Allowances  to  children,  relatives,  or  dependents 


TRUST  COMPANIES  AND  THE  FINANCIAL  SYSTEM      321 

In  other  words,  the  service  is  not  confined  within  formal  limits, 
but  responds  to  the  needs  of  our  depositors. 

2.  Transfer  of  securities.  We  are  pleased  to  undertake  to  efiFect 
the  transfer  of  stock  certificates  and  registered  bonds  which  our 
clients  desire  to  have  transferred  either  to  their  own  names  or  to 
the  names  of  beneficiaries  under  wUls  or  deeds  of  trust. 

3.  Care  of  securities  for  executors,  administrators,  guardians,  and 
committees.  Individuals  acting  in  the  capacity  of  executors,  admin- 
istrators, guardians,  trustees,  or  as  committee  for  incompetent  per- 
sons having  securities  in  their  charge,  instead  of  placing  the  securities 
in  safe  deposit,  may  be  relieved  of  the  routine  care  and  trouble 
in  handling  securities  by  depositing  them  in  the  custody  of  the 
Company. 

The  foregoing  services  as  custodian  are  performed  for 
individuals.  Trust  companies  also  act  as  custodians  of  the 
securities  of  firms  and  corporations.  Modern  enterprises  often 
invest  surplus  fimds,  reserves,  etc.,  in  securities,  and  the 
deposit  of  such  securities  with  a  trust  company  eliminates  the 
expense  of  providing  costly  and  secure  vaults  and  renders  it 
unnecessary  to  require  the  giving  of  bonds  by  employees  for 
the  faithful  discharge  of  their  responsibilities. 

Trust  companies  perform  many  services  for  "correspondent 
banks"  and  brokerage  houses.  In  connection  with  out-of-town 
banks  and  brokerage  houses,  both  in  the  United  States  and 
abroad,  correspondent  banking  houses  which  deposit  securities 
for  safe-keeping  in  New  York  are  given  practically  all  the 
facilities  of  a  branch  office.  A  trust  company  in  New  York 
provides  a  place  where  all  matters  pertaining  to  the  purchase 
and  sale  of  securities  may  be  cared  for,  thereby  obviating 
(a)  delay  in  making  settlement,  {b)  delay  in  shipping  securities 
to  and  from  New  York,  (c)  expense  of  postage,  expressage, 
and  insurance.  The  trust  company  also  collects  interest 
coupons  and  credits  the  amount  to  the  correspondent  banks, 
thus  saving  delay  and  expense  in  making  collections.  (This 
service  is  of  importance  for  the  reason  that  most  large 
corporations  maintain  an  agency  for  the  payment  of  their 
coupons  in  New  York  City.)  The  trust  company  also  prepares 
income-tax  certificates  for  out-of-town  banks;  it  looks  after 


322         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  collection  of  dividends,  in  many  cases;  and  it  provides  facili- 
ties for  effecting  transfers  of  ownership  of  securities.  Nearly 
all  of  the  great  corporations  of  the  country  maintain  offices  or 
agencies  in  New  York  where  their  securities  may  be  transferred 
and  registered.  A  representative  of  the  trust  company  is  thus 
in  a  position  by  personal  interview  "  to  discuss  difficult  questions 
with  the  various  offices  or  agencies  and  to  ascertain  the  proper 
papers  to  effect  transfers,  thus  obviating  the  delay  which 
usually  occurs  when  the  matter  is  handled  by  letter. " 

Foreign  correspondent  banks  which  deal  in  American 
securities  find  it  of  very  great  service  to  have  an  agency  in 
New  York.  This  is  especially  true  when  securities  issued 
stand  in  the  name  of  decedents,  executors,  administrators," 
trustees,  or  guardians;  for  in  cases  of  this  sort,  the  trust  com- 
pany relieves  the  correspondent  banks  from  the  necessity  of 
familiarizing  themselves  with  the  diverse  requirements  of  the 
different  corporations  and  of  the  particular  laws  of  the  several 
states. 

VI.    THE  REGULATION  OF  TRUST  COMPANIES 

There  is  little  to  be  said  on  the  subject  of  trust  company 
regulation,  for  the  reason  that  the  trust  companies,  Uke  the 
investment  banks,  have  developed  without  being  subjected  to 
much  legislative  control,  except  in  connection  with  their 
banking  departments.*  In  general,  the  state  laws  under 
which  they  are  chartered  have  conferred  upon  them  very 
broad  grants  of  power  and  they  have  been  enabled  to  develop 
along  pragmatic  lines.  While  practically  free  from  legislative 
restrictions  so  far  as  their  non-banking  departments  are  con- 
cerned, trust  companies  are,  however,  subject  to  the  laws 
pertaining  to  trust  and  agency  business  in  general.  There 
appears  to  be  little  doubt  that  these  laws  have,  on  the  whole, 
been  sufficient  to  insure  the  faithful  performance  of  the  manifold 
duties  which  trust  companies  assume. 

'  This  phase  of  trust  company  regulation  will  be  consideretj  in  chap. 
%jax  belpw. 


TRUST  COMPANIES  AND  THE  FINANCIAL' SYSTEM      323 

This  general  survey  of  the  broad  scope  of  trust  company 
operations  is  sufl5cient  to  disclose  the  very  important  part  that 
these  institutions  play  in  the  modern  economic  system.  In  a 
very  real  sense  it  may  be  said  that  the  development  of  some 
such  institution  was  indispensable  to  the  growth  of  the  large- 
scale  corporate  form  of  capitalistic  enterprise  involving  so 
many  details  of  financial  management  and  so  difficult  a  task  of 
safeguarding  the  equities  both  of  the  corporate  enterprise  itself 
and  the  owners  of  its  securities.  Similarly,  the  great  accumu- 
lation of  wealth  during  the  last  few  generations  has  rendered  it 
practically  impossible  for  individuals  to  serve  efficiently  as 
trustees  of  estates,  etc. 

As  pointed  out  at  the  beginning,  however,  the  analysis  in 
this  chapter  pertains  only  to  certain  phases  of  the  work  per- 
formed by  the  department-store  financial  institution  that  is 
organized  under  the  title  of  trust  company.  While  the  banking 
and  bondhouse  functions  of  trust  companies  are  necessarily 
discussed  in  other  chapters  of  this  functional  analysis,  it  is 
important  to  point  out  here  that  an  institution  such  as  the 
trust  company,  which  performs  practically  every  type  of 
financial  operation  under  one  roof,  is  in  many  ways  a  highly 
advantageous  type  of  business  organization.  We  shall  see  in 
chapter  xxix  how  its  development  is  rapidly  serving  to  eliminate 
specialization  in  the  field  of  financial  enterprise  and  forcing  all 
financial  institutions  to  assume  in  greater  or  less  degree  the 
department-store  form  of  organization. 

QUESTIONS  FOR  DISCUSSION 

1.  How  do  you  account  for  the  fact  that  the  growth  of  trust  com- 
panies did  not  become  rapid  until  about  1880?  Why  was  it 
especially  rapid  after  igcx)? 

2.  Before  the  development  of  trust  companies,  how  were  individual 
"trusts"  handled? 

3.  Which  types  of  trust  company  operations,  as  shown  on  pages 
302-3,  are  most  important  from  the  standpoint  of  (a)  individuals, 
(b)  corporations? 

4.  Make  a  list  of  the  services  that  are  rendered  to:  (a)  individuals, 
(6)  corporations. 


324         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

5.  Do  you  regard  '.'living  trusts"  as  important  ? 

6.  "A  trust  company  is  preferable  to  individual  trustees,  because 
it  possesses  every  quality  of  desirability  which  the  individual 
lacks,  to  wit: 

"fl)  It  does  not  die. 

"b)  It  does  not  go  abroad. 

"c)  It  does  not  become  insane. 

"d)  It  does  not  imperil  the  trust  by  failure  or  dishonesty. 

"e)  It  does  not  refuse  to  act  from  caprice  or  on  the  ground  of 

inexperience. 
"f)  It  does  not  resign. 

"g)  It  has  no  sympathies  or  antipathies  and  no  politics. 
"A)  It  is  absolutely  confidential. 
"t)  It  is  invariably  on  hand  during  business  hours  and  can  be 

consulted  at  all  times. 
"j)  It  never  neglects  its  work  or  hands  it  over  to  untrustworthy 

people. 
"k)  Its  experience  and  judgment  in  trust  matters  are  beyond 

dispute." 
Do  you  agree  with  all  of  these  contentions  ? 
/.  "Trust  companies  to  a  considerable  extent  do  away  with  the 
element  of  personal  risk  attaching  to  an  individual  trustee;  but 
they  lack  the  advantages  of  personal  management.  These  com- 
panies sometimes  fail  from  improper  management  as  utterly  as 
individuals  do,  and  as  a  rulfe  the  lack  of  personal  management 
results  in  securing  the  minimum  return,  only,  on  the  amount 
invested,  and  lacks  the  great  advantages  often  secured  by  the 
able  personal  oversight  of  individual  trustees." 
8.  "No  doubt  there  are  some  objectionable  features  in  having  for 
trustee  a  corporation  which  has  neither  a  body  to  be  kicked  nor 
a  soul  to  be  damned.  It  has  sometimes  been  said  that  the  trust 
companies  lack  the  advantage  of  personal  interest  that  attaches 
to  an  individual  trustee.  While  there  have  undoubtedly  been 
cases  where  trust  companies  have  been  inefficient  and  lax  in  the 
handling  of  trusts,  it  cannot  fairly  be  made  as  a  general  criticism 
that  the  interests  of  the  client  suffer  for  1  ack  of  the  personal 
touch.  It  all  comes  back  to  the  question  of  the  qualifications 
and  integrity  of  the  corporation's  officers  and  officials."  What 
is  your  judgment  on  the  issue  raised  in  ,this  and  the  preceding 
question  ? 


TRUST  COMPANIES  AND  THE  FINANCIAL  SYSTEM      325 

9.  In  what  respects  is  a  trust  company  superior  to  an  individual  in 
the  performance  of  agency  functions  ? 

10.  Draw  up  a  list  of  all  the  ways  in  which  the  trust  company  assists 
in  the  marketing  of  securities. 

11.  How  is  the  borrower  safeguarded  in  the  "equipment  trust" 
plan  of  raising  capital  ? 

12.  Why  is  a  transfer  agent  necessary?  Could  not  the  issuing  cor- 
poration take  care  of  this  work  quite  as  satisfactorily  as  an  agent  ? 

13.  What  habilities  do  you  think  the  trust  company  should  assume 
as  transfer  agent  ? 

14.  Would  it  not  be  better  to  require  the  state  government  which 
charters  the  corporation  to  act  as  transfer  agent,  rather  than  to 
have  an  independent  trustee  ? 

15.  Precisely  how  might  frauds  arise  in  the  absence  of  an  independent 
registrar  of  stock  ? 

16.  Why  is  it  important  to  have  different  trust  companies  serve  as 
transfer  agent  and  registrar  for  a  given  issue  ? 

17.  Do  you  understand  that  a  given  trust  company  might  be  the 
transfer  agent  for  one  corporation  and  registrar  for  another? 

18.  State  the  different  ways  in  which  a  trust  company  is  of  service 
in  connection  with  financially  embarrassed  or  insolvent  cor- 
porations. 

19.  In  the  absence  of  trust  companies  how  would  problems  such  as 
those  mentioned  on  pages  312-13  be  handled? 

20.  Which  of  the  various  services  listed  under  fiscal  agency  do  you 
regard  as  of  greatest  importance  to  a  corporation  ? 

21.  If  you  were  manager  of  a  corporation,  would  you  employ  a  trust 
company  to  act  as  fiscal  agent  or  would  you  manage  the  problems 

. involved  yourself  and  "save  the  fees"  ? 

22.  Do  non-profit-making  institutions  have  a  greater  or  less  need  for 
fiscal  agency  service  than  business  corporations  ?     Why  ? 

23.  Do  you  think  the  statement  is  true  that  the  custodian  services 
of  trust  companies  are  essentially  an  outgrowth  of  the  develop- 
ment of  corporate  enterprise  ? 

24.  In  what  respects  is  a  trust  company  a  more  desirable  custodian 
of  securities  than  an  individual  agent  ? 

25.  Would  the  amount  of  routine  work  required  in  caring  for  the 
collection  of  interest,  dividends,  principal,  etc.,  be  really  irksome 
to  an  individual  of  large  means?  Is  not  "clipping  coupons" 
supposed  to  be  a  congenial  vocation  ? 


326         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

26.  Draw  up  a  brief  statement  showing  what  it  would  be  necessary 
for  an  individual  to  do  in  order  to  prevent  avoidable  losses  on 
his  investment  holdings. 

27.  As  manager  of  a  corporation,  would  you  employ  a  trust  company 
to  take  the  custody  of  reserve  and  other  funds  ? 

28.  Is  it  only  the  trust  companies  of  the  great  financial  centers  that 
are  in  a  f)osition  to  render  important  services  to  correspondent 
banks  and  brokers  ? 

29.  Do  you  think  trust  company  operations — aside  from  banking — 
should  be  subjected  to  special  legislation,  or  are  the  general  laws 
of  trusts  and  agency  sufficient  ? 

30.  Draw  up  a  statement  of  the  economic  significance  of  trust 
companies. 

REFERENCES  FOR  FURTHER  READING 

Bamett,  George  E.:  Growth  of  State  Banks  and  Trust  Companies 
since  1865. 

Herrick,  Clay:  Trust  Companies,  Their  Organization,  Growth,  and 
Management. 

Kirkbride,  F.  B.,  and  Sterrett,  J.  E.:  The  Modern  Trust 
Company. 

Ferine,  E.  T.:  The  Story  of  the  Trust  Company. 

Noyes,  A.  D.:  "Trust  Companies,"  Political  Science  Quarterly, 
Vol.  XVI  (1901). 

Kilburn,  F.  D.:  "Control  and  Supervision  of  Trust  Companies," 
Annals  of  American  Academy,  Vol.  XXIV  (1904). 

Trust  Companies  of  the  United  States.  An  annual  volume 
pubhshed  by  the  United  States  Mortgage  and  Trust  Company, 
New  York. 

Trust  Companies.  A  monthly  magazine  published  by  thn  New 
York  Trust  Companies  Publishing  Association. 


CHAPTER  XVm 

THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS 

The  savings  bank  was  indicated,  in  the  charts  on  pages  134 
and  136,  as  a  financial  intermediary  in  the  raising  of  capital  for 
business  enterprises.  It  should  be  understood,  however,  that 
savings  institutions  also  assist  in  the  raising  of  funds  required 
by  governments — federal,  state,  and  local;  in  the  furnishing 
of  capital  for  agricultural  purposes;^  and  in  the  financing  of 
urban  real  estate  operations,  particularly  in  the  construction  of 
apartment  buildings. 

There  are  several  different  t3^es  of  savings  institutions, 
which  may  be  classified  as:  (i)  mutual  or  trustee;  (2)  stock; 
(3)  postal;  and  (4)  co-operative.  The  mutual  and  stock  sav- 
ings banks  are  by  far  the  most  important,  and  it  is  through 
them  that  the  bulk  of  savings  in  the  United  States  has  been 
effected.  Postal  savings  institutions,  which  are  designed  to 
encourage  and  facilitate  the  making  of  savings  by  people  in 
very  moderate  circumstances,  have  been  in  existence  in  the 
United  States  for  about  ten  years  only.  Co-operative  savings 
banks  are  institutions  organized  mainly  for  the  purpose  of 
promoting  thrift,  through  co-operative  action,  among  special 
groups  of  individuals.  They  include  building  and  loan  asso- 
ciations, fraternal  societies,  credit  unions,  etc.;  consideration 
of  these  institutions  will  be  reserved  for  the  chapter  on  co- 
operative credit.^ 

I.    STOCK  SAVINGS  BANKS 

If  one  is  clearly  to  understand  the  work  that  is  performed 
by  savings  institutions,  he  must  be  able  to  interpret  the  accounts 
that  are  shown  on  the  balance  sheet,  or  financial  statement. 
The  following  financial  statement  shows  the  combined  resources 

*  See  chart  on  p.  650.  » See  chap,  xzviii. 

327 


328 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


and  liabilities  of  1,194  stock  savings  banks  in  the  United 
States,  which  reported  to  the  Comptroller  of  the  Currency 
in  the  year  1918.* 

RESOURCES 


Loans  secured  by  real  estate 
Loans  secured  by  other  collateral   . 

Loans  unclassified 

Overdrafts 

United  States  bonds        .... 
State,  county,  and  municipal  bonds 

Railroad  bonds 

Other  public  service  bonds  . 

Unclassified  bonds  and  securities    . 

Banking  house,  furniture  and  fixtures 

Other  real  estate  owned 

Due  from  banks   . 

Checks  and  other  cash  items 

Cash  on  hand 

All  other  resoxxrces     . 


Total $1,183189,666.72 


26,485,117.31 

6,462,262.32 

753,836,471-52 

1,164,240.28 

30,856,802.85 

1,175,832.03 

2,663,188.31 

997,471.29 

174,064,438.26 

30,990,907.34 

7,584,861.65 

106,965,023.20 

3,487,606.09 

32,475,269.59 

3,980,174.68 


68,984,602.22 

34,639,336.29 

12,958,063.95 

2,672,459.56 

168,506.10 


UABILITIES 

Capital  stock 

Surplus  fund 

Undivided  profits 

Due  to  banks 

Dividends  unpaid 

Individual  deposits 1,049,483,555.47 

Postal  savings  deposits         670,962 .  70 

Notes  and  bills  rediscounted 253,392.33 

Bills  payable 7,608,359.66 

Other  liabilities 5,750,428.44 

Total $1,183,189,666.72 

The  purpose  of  a  balance  sheet  is  to  show  at  a  glance  the 
financial  condition  of  the  institution.  All  of  the  debts,  or 
obUgations,  of  the  bank  are  arrayed  under  the  heading  "liabili- 
ties," and  all  of  the  property  of  the  bank,  together  with  the 
debts  and  obUgations  owing  to  it,  are  grouped  under  "resources" 
or  "assets."    The  liabilities  of  a  stock  savings  bank  are  of 

*  Report  of  the  Comptroller  of  the  Currency,  I  (1918),  88-94. 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS  329 

two  classes:  those  to  the  stockholders,  and  those  to  the  creditors, 
or  customers,  of  the  institution.  The  stockholders'  liabilities 
are  classified  under  three  headings:  capital,  surplus,  and  undi- 
vided profits.  These  items,  taken  together,  represent  the  dif- 
ference between  the  total  amount  of  resources  and  the  liabilities 
to  the  creditors;  they  thus  represent  the  net  worth  of  the 
business—what  is  owned  by  the  proprietors. 

Many  accountants  refer  to  these  items  as  "proprietorship 
items,"  and  do  not  list  them  among  the  liabilities;  but  since  the 
financial  statements  of  banks  always  include  them  as  liabilities, 
we  shall  here  follow  the  latter  practice.  The  reason  for  classify- 
ing them  as  shareholders'  liabilities  may  be  understood,  if  one 
conceives  of  the  banking  corporation  as  a  business  entity  to 
which  the  stockholders  have  intrusted  their  funds  in  the  capacity 
of  investors.  Capital,  surplus,  etc.,  are  thus  owned,  not  by  the 
bank,  but  by  the  individuals  who  have  bought  its  certificates  of 
stock.  The  stockholders  have  the  shares  as  evidence  of  the 
obligation  of  the  bank  to  them;  and  in  turn  the  bank  must 
enter  on  its  books  a  statement  of  the  amount  of  capital  it  owes 
to  shareholders. 

The  origin  and  nature  of  the  remaining  items  on  the  balance 
sheet  may  best  be  made  clear  if  we  proceed  to  organize  a  bank 
and  work  out  by  the  use  of  entries  on  the  balance  sheet  the 
nature  of  its  operations  as  a  going  concern.  Suppose  we 
organize  a  bank  with  a  capital  of  $100,000,  to  be  derived  from 
the  sale  of  1,000  shares  of  stock  at  $100  per  share.  The  two 
original  entries  would  be  as  follows: 

RESOURCES  LIABILITIES 

Cash $100,000      Capital  stock  .     .     .    $100,000 

Mariy  persons  confuse  the  capital  of  a  bank  with  its  cash.  The 
making  of  this  balance  sheet  reveals  at  once  the  difference 
between  them.  Capital  stock  is  a  statement  on  the  books  of 
the  bank  of  the  amount  that  has  been  contributed  by  share- 
holders; and  the  entry  of  $100,000  under  cash  on  the  resources 
side  is  a  declaration  that  the  bank  has  $100,000  of  cash  in  its 
vaults. 


33©         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  meaning  of  surplus  and  undivided  profits  may  also  be 
made  clear  at  this  place.  Let  us  assume  that  the  stock,  whose 
par  value  was  $ioo  per  share,  was  actually  sold  at  $iio  per 
share.    The  statement  would  then  stand: 

RESOURCES  LIABILITIES 

Cash $110,000      Capital  stock   .      .      .    $100,000 

Surplus       ....        10,000 

The  surplus  is  thus  a  statement  that  the  stockholders  have  con- 
tributed more  than  the  par  value  of  the  stock.  The  surplus 
may,  however,  also  be  increased  from  year  to  year  through  a 
policy  of  not  disbursing  all  the  earnings  among  the  stockholders 
in  the  form  of  dividends.  If,  for  instance,  at  the  end  of  the  year 
the  directors  of  the  bank  should  decide  that  $10,000  of  net 
earnings  should  be  retained  in  the  business,  the  surplus  would 
be  increased  by  $10,000.  This  additional  $10,000  would  be 
represented  on  the  resources  side  by  cash  or  investments. 

The  undivided-profits  item  states  the  amount  of  accumu- 
lated earnings,  aside  from  the  surplus;  and,  like  the  other  items, 
it  is  represented  on  the  resources  side  by  cash,  or  other  assets. 
When  dividends  are  declared  and  paid,  the  undivided-profits 
account  is  lessened  by  the  amount  of  the  dividend  payment  and 
cash  is  reduced  by  the  same  amount. 

To  return  to  the  statement  as  it  stands  above,  it  is  obvious 
that  before  we  can  engage  in  the  banking  business  it  will  be 
necessary  for  us  to  have  a  building.  Let  us  assume  that  we 
buy  a  building  properly  furnished  and  equipped  for  the  pur- 
pose in  hand  at  a  cost  of  $35,000.  A  new  statement  of  the 
bank's  financial  position  would  then  read  as  follows: 

RESOURCES  LIABILITIES 

Bank  building,  furni-  •  Capital  stock   .  .    $100,000 

ture  and  fixtures     .      $35,000      Surplus       ....        10,000 
Cash 7S,ooo 

We  now  open  the  doors  of  the  bank  for  business  and  make 
public  announcement  of  the  fact  that  we  are  ready  to  receive 
deposits;  and  in  the  course  of  a  few  weeks  we  receive  $50,000 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS 


331 


from  individuals  for  deposit.    The  accounts  would  then  stand  as 
follows : 

RESOURCES 

Bank  building,  etc.     .      $35,000 
Cash 125,000 


LIABILITIES 

Capital  stock   . 
Surplus       .     .     .     . 
Deposits     .     .     .      . 


$100,000 
10,000 
50,000 


In  the  course  of  time  the  following  transactions  are  also 
concluded:  (i)  $10,000  is  deposited  by  our  bank  in  a  large 
commercial  bank  in  a  nearby  city,  on  which  we  are  to  receive 
2  per  cent  interest;  (2)  the  local  post-office  deposits  with  us 
$10,000  of  postal  savings;  (3)  $10,000  of  United  States  bonds, 
$6,000  of  state,  county,  and  municipal  bonds,  $10,000  of  railroad 
bonds,  $10,000  of  other  public  service  bonds,  and  $24,000  of 
unclassified  bonds  and  securities  are  purchased;  (4)  $20,000  of 
loans  are  made  on  real  estate  security;  (5)  $15,000  of  loans  are 
made  on  other  collateral,  mainly  stocks  and  bonds;  (6)  $30,000 
of  other  loans  (unclassified)  are  made,  mainly  on  the  promissory 
notes  of  individuals;  and  (7)  $5,000  is  borrowed  from  another 
bank. 

A  financial  statement  of  the  bank's  afifairs  would  then  stand 
as  follows: 


RESOURCES 

LIABILITIES 

Bank  building,  etc 

$35,000 

Capital  stock   .     .     .    $100,000 

Due  from  banks . 

10,000 

Surplus       ....        10,000 

United  States  bonds  . 

10,000 

Deposits     ....        50,000 

State,  county,  and  mu- 

Postal savings  deposits       10,000 

nicipal  bonds 

6,000 

Bills  payable    .     .     .          5,000 

Railroad  bonds 

10,000 

$175,000 

Other    public    service 

bonds      .... 

10,000 

Unclassified  bonds  and 

securities 

24,000 

Loans  secured  by  real 

estate      .... 

20,000 

Loans  secured  by  other 

collateral 

15,000 

Loans  unclassified 

30,000 

Cash 

5,000 

$175,000 


332         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

As  a  result  of  these  operations  it  will  be  seen  that  the 
bank's  cash  has  been  very  greatly  reduced  and  that  funds  have 
been  advanced  through  loans  and  the  purchase  of  securities  to 
governments  and  to  the  various  types  of  private  enterprise. 
In  these  operations  we  have  accounted  for  nearly  all  of  the 
items  that  appear  upon  the  combined  statement  of  the  stock 
savings  banks  in  the  United  States. 

A  word  of  explanation  will  indicate  the  origin  of  the  other 
items.  "Overdrafts"  arise  whenever  a  depositor  is  permitted 
to  withdraw  from  the  bank  more  than  he  has  on  deposit;  it 
is  thus  an  unsecured  loan,  and  represents  bad  banking  practice. 
"Checks  and  other  cash  items"  will  become  cash  as  soon  as 
presented  for  payment  to  the  banks  or  individuals  upon  which 
they  are  drawn.  "Due  to  banks"  is  a  statement  of  deposits 
that  have  been  made  in  this  bank  by  other  banks;  the  entry 
might  be  designated  "bank  deposit,"  in  contrast  with  "indi- 
vidual deposit"  and  "postal  savings  deposit"  accounts.  The 
item  "notes  and  bills  rediscounted"  shows  that  some  of  the 
notes  which  lie  back  of  the  unclassified  loans  on  the  resources 
side  have  been  used  by  the  bank  as  a  basis  for  borrowing  from 
other  banks. 

II.    MUTUAL  SAVINGS  BANKS 

While  stock  savings  banks  are  located  mainly  in  the  Middle 
West,  the  mutual  institutions  are  confined  chiefly  to  the  manu- 
facturing centers  and  towns  of  the  New  England  and  eastern 
states.  The  mutual,  or  trustee,  savings  bank  does  not  possess 
any  capital  stock,  the  funds  being  derived  solely  from  deposits. 
The  depositors  are  thus  the  mutual  owners  of  the  bank.  They 
do  not  receive  interest  on  deposits;  but  the  net  earnings  of  the 
company  are  divided  among  them  in  the  form  of  interest  and 
profits.  The  mutual  institutions  are  not  managed  by  a  board 
of  directors  elected  by  the  stockholders,  but  by  a  body  ol 
non-depositing  trustees,  who  usually  hold  office  perpetually 
and  who  are  actuated  mainly  by  the  desire  to  render  a 
public  service  through  the  faithful  discharge  of  a  responsibk 
trust. 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS         333 

The  "guaranty  savings  hank"  is  a  mongrel  type.  The  state 
of  New  Hampshire  has  what  is  known  as  the  "guaranty  savings 
bank,"  a  combination  of  the  mutual  and  stock  institution.  The 
guaranty  savings  bank  accepts  both  regular  and  "special" 
deposits.  The  latter  are  in  effect  its  capital  stock.  The  mutual 
or  regular  depositors  are  paid  a  certain  stipulated  rate  of  inter- 
est, and  any  excess  of  earnings  above  this  is  available  for 
dividends  on  the  "special  deposits."  It  is  in  this  agreement 
to  pay  a  stipulated  rate  of  interest  to  mutual  depositors  that 
the  guaranty  savings  bank  differs  essentially  from  the  mutual 
institution.  The  term  "guaranty"  is  derived  from  the  fact 
that  the  special  deposits  comprise,  like  capital  stock  and 
surplus  in  a  stock  savings  bank,  a  sort  of  guaranty  fund  for 
the  general  depositors,  the  earnings  derived  from  the  use  of  the 
special  deposits  being  available  for  payment  of  interest  to 
mutual  depositors. 

There  follows  a  statement  of  the  total  resources  and  liabili- 
ties of  625  mutual  savings  banks  reporting  to  the  Comptroller 
of  the  Currency  in  1918:^ 

RESOURCES 

Loans  secured  by  real  estate $2,065,553,657.87 

Loans  secured  by  other  collateral  security      .     .  128,216,466.69 

Loans  unclassified 120,972,809.58 

United  States  bonds 77,719,949.27 

State,  county,  and  municipal  bonds    ....  214,257,761.62 

Railroad  bonds 406,272,168.88 

Other  public  service  bonds 79,015,464.73 

Unclassified  investments 1,396,556,360.70 

Banking  house,  furniture  and  fixtures       .     .     .  41,160,918.63 

Other  real  estate  owned       .     .    - 24,333,145.89 

Due  from  banks 202,898,003.08 

Checks  and  cash  items 1,253,422.47 

Cash  on  hand 24,132,875.91 

Resovirces  not  classified 36,217,357.37 


Total $4,818,560,362.69 

'  Report  of  the  Comptroller  of  Currency,  I  (1918),  88,  91. 


334         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

LIABILITIES 

Surplus $   315,631,490.78 

Undivided  profits 58,792.522.91 

Due  to  banks 341,519.02 

Individual  deposits 4,422,096,393.15 

Postal  savings  deposits 757  00 

Notes  and  bills  rediscounted     .     .     .     .     .     .  2,259.42 

Bills  payable 1,572,718.83 

Other  liabilities 20,122,701.58 

Total $4,818,560,362.69 

It  will  be  noted  that  in  the  mutual  banks  investments  are 
larger  relatively  to  loans  than  in  the  stock  banks,  and  that  the 
volume  of  investments  in  state,  county,  and  municipal  bonds, 
railroad  bonds,  and  public  service  bonds  is  much  larger  rela- 
tively than  in  the  stock  institutions.  Loans  secured  by  real 
estate  are  proportionally  much  greater  in  the  mutual  institu- 
tions. These  differences  are  for  the  most  part  attributable  to 
the  dififerences  in  the  legal  regulations  pertaining  to  investment 
in  the  eastern  and  western  states. 

m.    SAVINGS  DEPARTMENTS  IN  COMMERCIAL 
BANKS 

The  mutual  and  stock  savings  banks  are  not  the  only 
savings  institutions,  for  the  commercial  banks  of  the  country 
also  have  savings  departments  which  have  come  to  play  a  very 
important  role  in  the  raising  of  funds.  Most  state  commercial 
banks,  particularly  in  the  South  and  West,  have  always  received 
savings  accounts  to  a  greater  or  lesser  degree;  in  many  cases, 
indeed,  it  has  been  found  that  a  so-called  commercial  bank 
does  mainly  a  savings  business.  Trust  companies,  moreover, 
almost  universally  have  savings  departments. 

The  development  of  savings  departments  in  national  banks 
is  a  matter  of  the  last  twenty  years;  for  until  an  important 
decision  was  rendered  by  the  Comptroller  of  the  Currency  in 
1903,  there  were  only  a  few  national  banks  that  had  savings 
departments,  the  majority  of  them  believing  that  it  was  illegal 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS  335 

to  accept  savings  accounts.  In  answer  to  a  question  from  a 
western  banker  whether  a  national  bank  could  operate  a  sav- 
ings department,  Comptroller  Ridgeley  stated: 

There  does  not  appear  to  be  anjrthing  in  the  National  Bank  Act 
which  authorizes  or  prohibits  the  operation  of  a  savings  department 

by  a  national  bank The  expediency  of  the  National  Bank 

Association,  organized  for  the  purpose  of  doing  the  business  of  dis- 
count and  deposit,  engaging  in  the  business  of  a  savings  bank  is 
one  for  the  determination  of  the  Board  of  Directors. 

Because  of  the  strong  competition  for  deposits  among  the 
different  t)T)es  of  banks,  the  national  institutions  rapidly 
availed  themselves  of  the  privilege  granted  under  this  decision 
and  established  savings  departments.  By  191 2  about  45  per 
cent  of  all  national  banks  had  taken  action  in  this  direction. 
The  movement  was  further  facilitated  when  the  Federal 
Reserve  Act  of  1913  formally  recognized  the  existence  of  sav- 
ings departments  in  national  banks  and  provided  that  a  reserve 
of  only  3  per  cent  need  be  kept  against  "time  deposits."  The 
growth  of  the  savings  business  in  national  banks  since  then  is 
shown  by  the  following  figures:  on  August  9,  1913,  the  aggre- 
gate of  savings  deposits  was  $820,000,000;  on  December  19, 
1919,  it  was  $2,293,000,000.  This  growth  is  obviously  not 
entirely  attributable  to  the  general  rise  in  prices  that  has 
occurred. 

IV.    POSTAL  SAVINGS  BANKS 

The  agitation  for  a  postal  savings  bank  system  in  the 
United  States  began  as  early  as  1871,  when  the  first  postal 
savings  bill  was  introduced  into  Congress.  In  the  ensuing 
years  about  eighty  bills  for  the  establishment  of  a  postal  sav- 
ings system  were  advanced,  and  the  system  was  strongly 
advocated  by  eight  different  postmasters-general  of  the  United 
States.  It  was  not  imtil  1910,  however,  that  postal  savings 
banks  were  finally  established  in  this  country. 

The  chief  argument  for  the  postal  savings  system  was  that 
it  would  stimulate  saving  among  people  in  moderate  circum- 
stances, particularly  the  immigrant  class,  who  either  distrusted 


336  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  regular  savings  institutions  or  found  their  facilities  incon- 
venient or  inadequate.  The  panic  of  1907,  which  made  it 
impossible  for  many  of  the  savings  banks  to  pay  deposits  on 
demand,  greatly  augmented  the  dissatisfaction  with  private 
savings  banks  and  accelerated  the  movement  for  public  insti- 
tutions. The  savings  facilities  of  the  country  were  not,  in 
fact,  evenly  distributed,  a  large  percentage  of  the  savings 
banks  being  concentrated  in  a  few  states  of  the  union.  In  the 
South  and  West,  particularly,  opportunities  for  depositing 
money  in  savings  banks  were  said  to  be  quite  inadequate, 
although  those  who  made  this  statement  usually  overlooked 
the  fact  that  state  and  national  commercial  banks,  particularly 
the  former,  furnished  facilities  for  savings.  Nevertheless,  it  was 
widely  believed  that  if  the  Post-Ofl&ce  Department  should 
open  offices  in  cities,  towns,  and  villages  not  provided  with 
adequate  savings  facilities,  economy  and  thrift  would  be  greatly 
promoted  and  funds  which  would  otherwise  be  hoarded  or  sent 
abroad  by  immigrants  for  deposit  in  European  postal  savings 
banks  would  be  made  available  for  investment  purposes  in  this 
country. 

The  main  objection  to  the  postal  savings  system  was  raised 
by  a  special  interest,  namely,  the  existing  savings  and  commer- 
cial banks  of  the  United  States.  These  banks  urged  that  the 
existing  facilities  were  fairly  adequate  and  that  for  the  govern- 
ment to  invade  the  field  of  banking  was  an  unwarranted  inter- 
ference with  private  initiative.  As  we  shall  see,  the  fear  on 
the  part  of  bankers  that  postal  savings  would  lessen  the  volume 
of  their  deposits  has  been  rendered  groundless  by  certain  pro- 
visions of  the  act  designed  to  protect  the  regular  savings 
institutions. 

The  following  are  the  important  provisions  of  the  postal 
savings  law: 

An  account  may  be  opened  and  deposits  made  by  any  person  of 
the  age  of  ten  years  or  more,  in  his  or  her  own  name,  and  by  a  married 
woman  in  her  own  name,  and  free  from  any  control  or  interference 
by  her  husband;  but  no  person  may  at  the  same  time  have  more 
than  one  postal  savings  account. 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS         337 

Deposits  will  be  accepted  only  from  individuals  and  no  account 
will  be  opened  in  the  name  of  any  corp)oration,  association,  society, 
firm,  etc.,  or  in  the  names  of  two  or  more  persons  jointly.  No  account 
will  be  made  in  trust  for  another  person  (as  is  the  case  in  many  foreign 
countries). 

No  person  may  ordinarily  have  a  deposit  account  in  excess  of 
$1,000,  exclusive  of  accumulated  interest,  except  by  special  authoriza- 
tion of  a  board  of  trustees  (an  official  board  for  the  supervision  of  the 
system,  composed  of  the  Postmaster  General,  Secretary  of  the  Treas- 
ury, and  the  Attorney  General  of  the  United  States).  With  such 
authorization  additional  deposits  may  be  accepted  "not  to  exceed  in 
the  aggregate  $1 ,000  for  each  depositor,  but  upon  which  no  interest 
shall  be  paid." 

No  account  may  be  opened  for  less  than  one  dollar,  nor  will 
fractions  of  one  dollar  be  accepted  for  deposit  at  any  time. 

The  interest  rate  shall  be  2  per  cent  on  deposits  which  have 
remained  for  at  least  one  year,  and  will  be  computed  only  from  the 
first  of  the  month  following  the  day  on  which  the  deposit  was  made. 

Postal  savings  deposits  will  be  evidenced  by  certificates  of  deposit 
issued  in  the  name  of  the  depositor.  These  will  be  non-transferable 
and  non-negotiable. 

To  enable  any  person  to  accumulate  and  deposit  amounts  less 
than  one  dollar,  depository  offices  will  keep  for  sale  postal  savings 
cards  at  ten  cents  each  and  ten-cent  postal  savings  stamps  which 
may  be  affixed  to  the  cards.  One  card  and  nine  stamps  will  be 
accepted  as  a  deposit  of  one  dollar. 

Any  depositor  may  withdraw  the  whole  or  part  of  his  funds  by 
surrendering  at  the  depository  office  the  savings  certificates  properly 
indorsed.  The  postal  savings  funds  shall  be  deposited  by  the  post- 
masters in  certain  designated  depository  banks,  which  may  be  either 
national  or  state,  savings  or  commercial  banks.  If  no  local  bank  has 
qualified  in  a  particular  town  or  locality,  then  the  funds  shall  be 
deposited  in  a  qualified  bank  which  is  most  convenient  to  such  locality. 
The  depository  banks  pay  interest  of  2j  per  cent  per  annum  on  the 
funds  received.  No  bank,  however,  is  allowed  to  receive  a  total 
sum  greater  than  its  capital  and  half  of  its  surplus. 

Five  per  cent  of  the  funds  received  by  any  depository  bank  shaU 
be  turned  over  to  the  board  of  trustees  and  be  kept  with  the  Treasurer 
of  the  United  States  as  a  lawfvd  money  reserve  against  postal  savings 
deposits. 


338         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Before  any  bank  is  qualified  to  receive  postal  savings  deposits, 
it  must  turn  over  to  the  board  of  trustees  of  the  postal  savings  system 
public  bonds  or  other  securities  approved  by  the  board  of  trustees 
and  deemed  sufficient  and  necessary  to  insure  the  safety  and  prompt 
payment  of  such  deposits  on  demand. 

If  at  any  time  the  postal  savings  deposits  in  any  city  exceed  the 
amount  which  the  quaUiied  banks  therein  are  willing  to  receive  under 
the  terms  of  this  act,  the  board  of  trustees  may  invest  all  or  any  part 
of  such  amoimt  in  bonds  and  other  securities  of  the  United  States. 
And  if,  in  the  judgment  of  the  President  of  the  United  States,  the 
general  welfare  and  interest  of  the  United  States  require  it,  the  board 
of  trustees  may  invest  all  or  any  part  of  the  postal  savings  funds, 
except  the  reserve  ftmd  of  5  per  cent,  in  bonds  and  other  securities  of 
the  United  States. 

Any  profits  received  by  the  Post-Office  Department  shall  be 
covered  into  the  Treasury  of  the  United  States  as  a  part  of  the  postal 
revenue. 

The  limitation  of  the  account  of  any  one  depositor  to 
$1,000  does  not  measure  the  full  possibility  for  further  utilizing 
the  postal  savings  banks,  for  the  law  provides  a  means  whereby 
individuals  may  purchase  United  States  postal  savings  bonds 
paying  2^  per  cent  interest. 

Any  depositor  may  surrender  his  deposit  or  any  part  thereof  in 
stuns  of  twenty  dollars,  forty  dollars,  sixty  dollars,  eighty  dollars, 
one  hundred  dollars,  and  multiples  of  one  hundred  dollars  and  five 
himdred  dollars,  and  receive  in  lieu  of  such  sxurrendered  deposits, 
imder  such  regulations  as  may  be  established  by  the  board  of  trustees, 
the  amount  of  the  surrendered  deposits  in  United  States  coupon  or 
registered  bonds  of  the  denominations  of  twenty  dollars,  forty  dollars, 
sixty  dollars,  eighty  dollars,  one  hundred  dollars,  and  five  hundred 
dollars,  which  bonds  shall  bear  interest  at  the  rate  of  2^  per  centum 
per  annum,  payable  semiannually,  and  be  redeemable  at  the  pleasure 
of  the  United  States  after  one  year  from  the  date  of  their  issue  and 
payable  twenty  years  from  such  date. 

The  results  attained  under  the  postal  savings  system  have, 
on  tlte  whole,  fulfilled  the  expectations  of  its  advocates.  By 
the  end  of  the  fiscal  year  1913  there  were  12,151  post-offices 
which  were  receiving  postal  savings.     A  great  number  of  these, 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS         339 

however,  had  very  small  accounts  and  during  the  next  few 
years  a  considerable  percentage  of  them  were  discontinued. 
On  June  30,  1916,  there  were  8,421  postal  savings  banks  in 
the  United  States.  Of  tliis  number  1,648  had  deposits  of  less 
than  $100;  while  509  of  them  did  not  have  a  single  dollar  on 
deposit  at  the  end  of  that  fiscal  year.  It  is  thus  evident  that 
there  are  still  too  many  small  offices. 

As  was  anticipated,  the  depositors  in  the  postal  savings 
banks  are  largely  of  the  immigrant  class.  On  September  26, 
1916,  60  per  cent  of  the  625,000  depositors  were  born  outside 
of  the  United  States;  and  this  60  per  cent  owned  three-fourths 
of  all  the  deposits.  It  appears  also  that  the  proportion  of 
foreign  born  among  the  depositors  has  been  increasing. 

The  returns  also  show  that  the  postal  savings  funds  have 
come,  as  was  again  anticipated,  largely  from  hoards  and  from 
accumulations  that  would  otherwise  be  sent  abroad  by  our 
foreign-born  inhabitants.  It  is  interesting  to  note  also  that 
87  per  cent  of  the  postal  savings  bonds  purchased  are  in  regis- 
tered form  and  are  presumably  held  as  permanent  investments. 

V.    THE  MANAGEMENT  OF  SAVINGS  INSTITUTIONS 

The  successful  management  of  a  savings  bank  depends  upon 
the  recognition  of  two  main  principles:  first,  that  the  loans 
and  investments  must  be  of  a  conservative  type  and  widely 
distributed,  both  geographically  and  by  industries;  second,  that 
a  sufficient  reserve  of  cash  must  be  maintained  to  enable  the 
bank  to  pay  current  bills  and  to  meet  the  withdrawal  require- 
ments of  those  who  have  placed  funds  in  deposit  with  the  bank. 

With  a  view  to  insuring  the  conservative  management  of 
savings  institutions,  legislation  has  been  developed  which  pre- 
scribes the  character  of  the  loans  and  investments  that  may  be 
made  and  lays  down  provisions  regarding  the  maintenance  of 
reserves.  These  laws,  however,  vary  widely  in  different  states; 
and  in  some,  mainly  in  the  South  and  West,  there  is  no  legisla- 
tion at  all.  The  New  York  law,  applying  to  mutual  savings 
banks,  has  served  as  a  model  for  many  other  states,  and  a 


340         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

summary  of  its  provisions  will  therefore  indicate  the  most 
approved  form  of  savings  bank  legislation  at  the  present  time. 
The  following  are  the  types  of  investment  that  may  be  made: 

1.  In  the  bonds  of  the  United  States  and  New  York  state. 

2.  In  the  bonds  of  other  states  which  have  not  defaulted  within 
ten  years. 

3.  In  the  municipal  bonds  of  New  York  state  municipalities. 

4.  In  the  bonds  of  any  city  in  a  state  admitted  to  statehood  prior 
to  1896,  and  which  has  not  defaulted  on  any  of  its  bonds  since  1861. 
The  debt  of  such  a  city,  however,  must  not  exceed  7  per  cent  of  its 
assessed  valuation. 

5.  In  the  first  mortgages  on  real  estate  in  New  York  state.  Such 
mortgages  must  not  exceed  60  per  cent  of  the  value  of  improved 
property  or  40  per  cent  of  the  value  of  unimproved  property. 

6.  In  the  first  mortgage  bonds  of  strong  railroads  which  have 
paid  for  at  least  five  years  dividends  at  the  rate  of  4  per  cent  on 
their  stock;  but  the  stock  must  be  at  least  equal  in  amount  to  one- 
third  the  debt  of  the  road. 

7.  In  the  first  mortgage  bonds  of  railroads  in  New  York  on  the 
same  conditions.  Not  more  than  25  per  cent  of  the  deposits  shall 
be  invested  in  railroad  bonds  and  not  more  than  10  per  cent  in  the 
bonds  of  any  one  road. 

The  provisions  of  this  law  do  not  permit,  much  less  insure, 
a  wide  distribution  of  risks;  emphasis  is  rather  placed  upon  the 
necessity  of  "patronizing  home  industry."  The  distribution  by 
industries  is  also  somewhat  restricted,  owing  to  the  emphasis 
that  has  necessarily  been  placed  upon  very  conservative 
securities. 

As  a  rule  mutual  savings  banks  are  not  required  by  law 
to  hold  any  minimum  cash  reserve;  but  interestingly  enough 
a  maximum  reserve  is  usually  named,  on  the  theory  that 
unnecessary  reserves  constitute  idle  money  and  that  the  trustees 
need  to  be  discouraged  from  allowing  funds  to  accumulate. 
The  New  York  law,  for  example,  provides  that  any  mutual 
savings  bank  may  keep  on  hand  or  on  deposit  with  any  national 
bank.  New  York  state  bank,  or  trust  company  an  available 
fund  not  exceeding  20  per  cent  of  its  deposits.  Stock  sav- 
ings banks,  on  the  other  hand,  are  in  many  states  required  to 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS         341 

maintain  a  minimum  reserve  in  specie,  commonly  from  5  to 
10  per  cent. 

The  maintenance  of  a  proper  reserve  is  the  pivotal  problem 
in  savings  bank  management.  The  cash  reserve  of  a  bank  may 
ift  defined  as  the  ratio  of  its  cash  resources  to  its  deposit 
liabilities.  For  instance,  in  the  final  statement  of  the  bank 
that  we  have  organized  above,  the  cash  stands  at  $5,000  and  the 
individual  deposits  at  $50,000,  giving  a  reserve  of  lo  per  cent. 
The  bank  has  thus  committed-  itself  to  pay  $50,000  to  indi- 
viduals, although  it  has  at  the  moment  only  $5,000  in  cash  on 
hand.  The. ability  of  a  savings  bank  to  "get  by"  with  a  small 
cash  reserve — it  may,  in  fact,  be  much  less  than  10  per  cent — 
depends  in  part  upon  the  nature  of  the  agreement  with  the 
depositors — whether  the  depositors  are  to  be  paid  upon  demand 
or  only  at  the  expiration  of  a  thirty-  or  sixty-day  notice  of 
withdrawal;  it  also  depends  in  part  upon  the  readiness  with 
which  the  bank  can  convert  some  of  its  assets  into  cash  at  a 
moment's  notice  or  borrow  the  funds  required  from  some  other 
financial  institution. 

Legally,  savings  banks  have  the  right  to  require  a  notice  of 
withdrawal  from  depositors;  and  it  is  commonly  said  that  sav- 
ings banks,  therefore,  do  not  need  to  keep  their  resources  in  a 
form  where  they  can  be  readily  converted  into  cash.  But  in 
practice  this  right  to  demand  a  notice  is  nowadays  seldom 
exercised.  As  an  accommodation  to  the  depositors,  the  savings 
banks  early  developed  the  practice  of  paying  depositors  on 
demand,  whenever  it  was  convenient  for  them  to  do  so.  The 
result  was  that  the  depositors  soon  came  to  consider  that  the 
savings  bank  informally  agreed  to  return  their  funds  whenever 
they  were  needed,  notwithstanding  the  formal  requirement  that 
notice  of  withdrawal  be  given.  The  keen  competition  for 
deposits  among  savings  banks  gradually  led  to  an  all  but 
universal  abandonment  of  the  practice  of  requiring  notice  of 
withdrawal,  even  though  at  times  it  was  not  convenient  for 
the  savings  banks  to  meet  depositors'  demands.  The  competi- 
tion of  commercial  banks,  who  never  have  required  notice  of 
withdrawal,  also  aided  in  nullifying  the  withdrawal  provision; 


342         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

for  the  typical  depositor  regards  a  bank  as  a  bank  and  does 
not  carefully  distinguish  between  savings  and  commercial  insti- 
tutions. The  following  quotation  from  a  prominent  savings 
bank  president  indicates  the  prevailing  attitude  on  the  question 
of  enforcing  the  provision  that  notice  must'  be  given  befor# 
withdrawal: 

In  the  final  analysis  it  is  the  ability  to  pay  depositors  on  demand 
that  constitutes  good  banking  and  inspires  confidence.  Your  funds 
may  be  invested  in  securities  of  the  highest  order,  your  loans  made 
with  the  greatest  care,  but  if,  whenever  there  is  a  depression,  deposi- 
tors are  required  to  give  notice  of  withdrawal,  their  confidence  is 
shaken  and  they  will  eventually  cease  doing  business  with  savings 
banks  and  deposit  their  moneys  with  institutions  which  wiU  pay 
without  notice. 

Savings  institutions  now  make  many  loans  for  working  capital 
purposes.  It  has  always  been  difficult  in  times  of  financial 
strain  for  savings  banks  to  pay  depositors  on  demand.  Legis- 
lation often  restricted  investments  to  a  very  narrow  range 
of  securities — municipal  securities,  few  of  which  are  listed  on 
the  exchanges,  and  real  estate  mortgages  having  originally  been 
the  two  chief  t)^es  of  savings  bank  investments.  The  difficul- 
ties encountered  in  time  of  financial  strain  finally  led  to  an 
agitation  for  broadening  the  field  of  investments  to  include 
certain  readily  marketable  securities,  principally  railroad  bonds. 
While  the  agitation  was  successful,  it  was  again  found  in  the 
panic  of  1907  that  deposits  could  not  be  paid  on  demand. 

Since  the  panic  of  1907  the  belief  has  steadily  gained  ground 
that  savings  banks  should  invest  a  considerable  portion  of 
their  assets  in  short-time  promissory  notes  of  business  men 
and  in  bank  and  trade  acceptances,  to  the  end  that  in  time  of 
strain  they  may  be  in  a  stronger  position  to  acquire  cash.' 
And  the  savings  banks  have,  in  fact,  steadily  expanded  the 
volume  of  their  short-time  loans  in  recent  years.  The  financial 
statements  for  stock  savings  banks,  given  above,  show  that  the 
total  advances  made  in  the  form  of  loans,  exclusive  of  those  on 

'  We  shall  find,  however,  in  connection  with  our  study  of  commercial 
banking  in  succeeding  chapters  that  assets  of  this  sort  do  not,  in  fact, 
guarantee  that  the  bank  can  withstand  a  heavy  financial  strain. 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS  343 

real  estate,  are  nearly  four  times  the  total  investments.  While 
many  of  these  loans  are  doubtless  for  fixed  capital  purposes,  a 
considerable,  and  an  increasing,  percentage  of  them  are  for 
short-time  purposes.  Therefore,  in  the  diagram  on  page  136 
a  line  might  well  have  been  drawn  from  savings  banks  to  the 
working  capital  side  of  the  corporation,  for  many  of  their  loans 
to  customers  and  all  of  their  purchases  of  commercial  paper 
and  acceptances  furnish  funds  for  working  capital  purposes. 

It  has  been  customary  for  writers  on  banking  to  state  that 
it  is  the  function  of  commercial  banks  to  furnish  funds  for 
current  needs,  that  is,  for  working  capital  purposes,  and  of  the 
savings  banks  to  furnish  permanent,  or  fixed  capital.  How- 
ever true  this  statement  may  have  been  in  the  past,  the  bank 
statements  above  show  conclusively  that,  so  far  as  savings 
banks  are  concerned,  they  are  no  longer  institutions  which 
specialize  exclusively  in  the  raising  of  funds  for  fiixed  capital 
purposes.^ 

VI.    THE  PROFITS  OF  SAVINGS  BANKS 

The  profits  made  by  mutual  savings  banks  are  derived  from 
loaning  or  investing  the  funds  of  the  mutual  depositors.  The 
interest  received,  less  the  expenses  of  managing  the  institution, 
and  whatever  amount  is  kept  in  the  business  as  surplus  or 
undivided  profits,  is  distributed  to  the  depositors  semiannually 
in  the  form  of  dividends.  The  dividend  rates  vary  some- 
what in  different  states,  and  they  fluctuate  within  narrow 
b'mits  from  year  to  year  in  any  given  state  or  locality.  On 
the  whole,  they  may  be  said  to  average  about  4  per  cent. 
In  1914  the  general  average  was  3.86,  and  in  1913,  3.94  per 
cent.  The  highest  state  average  was  in  West  Virginia,  4.5 
per  cent,  and  the  lowest  in  Pennsylvania,  3.57  per  cent. 

The  profits  of  stock  savings  institutions  are  in  part  derived 
from  loans  and  investments  of  the  funds  contributed  by  share- 
holders, and  in  part  from  the  use  of  the  funds  of  depositors. 
The  returns  from  the  latter  source  may  in  a  sense  be  said  to 
represent   the   difference  between   the  interest  rate  paid  to 

'  See  pp.  731-32. 


344         THE  FmANClAL  ORGANIZATION  OF  SOCIETY 

depositors  and  the  interest  rate  received  on  the  bank's  loans 
and  investments.  Such  a  statement  does  not,  however, 
adequately  disclose  the  nature  of  the  problem  of  making  a 
savings  bank  pay. 

The  stock  savings  institution  must  tie  up  a  considerable 
proportion  of  its  capital  in  building  and  equipment;  it  must 
incur  no  little  expense  in  maintaining  an  official  and  clerical 
force,  providing  supplies,  etc.;  and  it  must  keep  a  reserve  of 
cash.  In  general  it  may  be  said  that  the  funds  contributed 
by  the  shareholders  are  largely  absorbed  in  these  ways — in 
providing,  as  it  were,  a  necessary  foundation  for  the  business 
of  receiving  deposits.  Directly  speaking,  the  profits  are  there- 
fore derived  from  loans  and  investments  of  depositors'  funds. 

Let  us  assume  that  a  savings  bank  has  a  capital  of  $100,000 
and  deposits  of  $1,000,000  and  that  the  funds  derived  from 
shareholders  are  all  absorbed  in  providing  the  building,  main- 
taining a  reserve,  etc.  If  the  bank  pays  3  per  cent  interest  on 
the  $1,000,000  of  deposits,  and  loans  out  $1,000,000  at  5  per 
cent,  the  profit  would  be  2  per  cent,  or  $2  on  every  $100  of 
deposits;  $2  on  every  $100  of  deposits  is  equal  to  $20  on  every 
$100  of  capital  stock,. or  earnings  of  20  per  cent.  It  will  be 
seen  therefore  that  the  amount  of  dividends  that  may  be  paid 
on  capital  stock  largely  depends  upon  the  volume  of  deposits. 

VII.    INSURANCE  COMPANIES  AS  SAVINGS 
INSTITUTIONS 

Discussion  of  the  work  of  insurance  companies  is  ordinarily 
approached  from  the  standpoint  of  their  primary  function  of 
affording  protection  to  life  and  property.  It  is  nevertheless 
commonly  recognized  that  the  savings  feature  of  life  insurance 
is  very  important.  Have  we  not  all  been  told  times  without 
number  that  an  endowment  policy  is  the  safest  investment  in 
the  world  and  that  the  most  certain  way  of  making  provision 
for  old  age  is  by  taking  out  insurance?  However  accurate 
this  statement  may  be,  it  is  certainly  true  that  the  insurance 
company  is  performing  a  service  that  is  identical  with  that  of 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS 


345 


the  ordinary  savings  bank;  it  is  an  intermediary  between  the  in- 
dividual savers  and  the  borrowing  enterprises  of  modern  society. 

The  insurance  company,  moreover,  assists  in  the  raising  of 
capital,  even  when  the  individual  payers  of  premiums  do  not 
have  in  mind  the  savings  feature  of  insurance.  For  all  of  the 
operations  of  each  of  the  various  types  of  insurance  companies 
—life,  fire,  marine,  etc. — -result  in  the  transfer  of  funds  from 
individual  savers  to  borrowers.  Whatever  the  reason  for  tak- 
ing out  insurance,  if  the  company  is  to  make  effective  use  of 
the  premiums  paid  in,  it  is  necessary  to  invest  the  funds  so 
received.  These  investments  always  mean  a  transfer  of  funds 
from  the  individuals  who  furnish  them  to  the  corporations 
whose  securities  are  purchased. 

The  insurance  company  is  sometimes  the  only  intermediary 
between  the  borrower  and  the  saver  of  funds;  and  sometimes 
it  is  a  secondary  intermediary  between  the  saver  and  the 
investment  banks  (see  the  diagram  on  p.  136).  Besides  making 
investments  in  securities,  insurance  companies  make  a  good 
many  short-time  loans  to  business  concerns.  They  also  make 
very  large  "policy  loans"  to  the  individuals  whom  they  have 
insured,  and  thus  play  an  important  part  in  the  extension  of 
funds  for  temporary  consumptive  or  productive  needs. 

The  following  table  of  the  assets  of  American  life  insurance 
companies  for  the  years  1904  to  1914  shows  the  nature  of 
their  loans  and  investments.    During  the  war,  life  insurance 

ASSETS  OF  AMERICAN  LIFE  INSURANCE  COMPANIES 


December  31,  igo4 

December  31,  1914 

Real  estate                

$    180,875,035 

671,577,813 

1,067,027,851 

172,582,975 

42,715,261 

189,738,779 
104,027,124 

45,879,455 
24,636,705 

$     171,173,551 

1,706,365,405 

1,981,751,698 

82,552,532 

20,351,766 

735,348,014 

05,160,^68 

Real  estate  mortgages 

Bonds                           

Stocks                       

Collateral  loans      

Policy  loans  and  premium  notes .  .  . 
Cash                      

Deferred  premiums 

68,832,680 
73,716,779 

All  other  assets 

Total  admitted  assets 

$2,499,060,998 

$4,935,252,793 

346         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

companies,  like  all  other  financial  and  business  institutions,  pur- 
chased a  great  number  of  liberty  bonds;  but  aside  from  this 
there  has  been  no  important  change  in  the  distribution  of 
investments  since  1914.^ 

The  assets  of  American  fire  insurance  companies  are  not 
available  for  a  similar  exhibit.  Because  of  the  nature  of  their 
operations  the  total  assets  are,  however,  much  smaller  than 
those  of  the  life  insurance  companies.  The  distribution  of 
their  -investments  probably  does  not  differ  essentially  from 
that  shown  in  the  table.  All  in  all  it  can  safely  be  said 
that  the  table  above  fairly  illustrates  the  r61e  that  insurance 
companies  play  in  the  raising  of  capital. 

A  consideration  of  the  distribution  of  life  insurance  invest- 
ments throws  light  upon  the  importance  of  these  institutions 
in  financing  different  types  of  business  enterprise.  It  will  be 
observed  that  investments  in  bonds  are  slightly  in  excess  of 
loans  on  real  estate  mortgages.  The  mortgage  loans  of  148  life 
insurance  companies,  comprising  gSj  per  cent  of  all  such  loans, 
were  divided  between  loans  on  farm  property  and  other  real 
estate  in  an  interesting  way.  Seventeen  companies  made  loans 
only  on  farm  property;  15  only  on  real  property  in  cities,  towns, 
and  villages;  and  116  made  loans  on  both  farm  and  city  proper- 
ties. The  amount  loaned  by  the  17  farm  loan  companies  was 
$12,827,709;  by  the  15  city  loan  companies,  $426,260,163; 
and  by  the  116  companies  loaning  on  both  farm  and  city 
property,  $1,158,014,595.  Of  the  total  mortgage  loans  of 
these  148  companies,  39.03  per  cent  were  in  United  States 
farms,  59.24  per  cent  on  other  real  property  in  the  United 
States  and  1.73  per  cent  on  real  estate  mortgages  of  Porto 
Rico  and  foreign  countries,  mainly  Canada. 

The  geographical  distribution  is  also  interesting.  In  the 
eastern  states  the  amount  loaned  on  farms  is  negligible;  in 
the  central,  northern,  and  southern  groups  farm  loans  rise  to 
considerable  totals;  but  it  is  in  the  southwestern  and  north- 
western sections  of  the  country  that  the  great  bulk  of  life 

'  The  author  has  been  unable  to  find  complete  data  for  a  later  year. 
This  table  was  taken  from  Inveslment  News,  V,  No.  2  (1916),  p.  24.  At  the 
present  time  (1920)  they  are  investing  heavily  in  government  bonds. 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS  347 

insurance  farm  loans  has  been  placed.  On  the  other  hand,  the 
loans  on  city  real  estate,  other  than  land,  have  mainly  been 
placed  in  the  populous  commercial  and  manufacturing  centers 
of  the  New  England  and  Middle  Atlantic  states,  which  contain 
almost  half  of  the  total  of  such  loans. 

Insurance  companies  may  keep  very  small  cash  reserves. 
The  cash  reserves  of  insurance  companies  may  ordinarily  be 
very  small  for  the  reason  that  they  have  no  deposits  subject 
to  withdrawal  on  demand.  Payments  are  made  whenever 
losses  are  sustained  or  whenever  policies  mature;  and  in  the 
case  of  a  large  company  these  payments  run  in  fairly  uniform 
amounts  and  can  be  met  out  of  current  receipts.  In  the  case 
of  unusual  losses,  larger  payments  of  course  have  to  be  made; 
but  some  time  necessarily  elapses,  while  the  company  is  making 
an  investigation  of  the  claim,  and  in  the  interval  there  is 
usually  plenty  of  opportunity  for  the  company  to  dispose  of 
some  of  its  investments.  It  is  obviously  necessary,  however, 
to  keep  a  fair  proportion  of  the  assets  in  readily  marketable 
securities.  This  fact  accounts  for  the  large  volume  of  bond 
investments  shown  in  the  foregoing  table,  as  well  as  for  the 
argument  that  they  should  invest  in  commercial  paper  and 
acceptances. 

The  growing  practice  of  making  loans  to  policy  holders  has 
given  rise  to  a  new  reserve  problem.  Policy  loans  are  made 
in  accordance  with  an  agreement  to  loan  a  certain  percentage 
of  the  surrender  value  of  the  policy  at  a  fixed  rate  of  interest 
at  any  time  the  insured  desires  such  a  loan.  The  growth  of 
this  practice  has  raised  the  question:  In  view  of  the  agreement 
to  make  loans  on  demand,  should  not  insurance  companies, 
,like  the  banks,  be  required  to  maintain  a  substantial  cash 
reserve,  and  to  invest  a  portion  of  their  assets  in  short-time 
commercial  paper  and  acceptances  ? 

In  the  absence  of  a  reserve  of  cash  or  liquid  assets,  it  is 
urged  that  insurance  companies  must  rely  in  times  of  stress 
upon  the  commercial  banks;  and  that  th^y  therefore  serve  to 
bring  added  pressure  upon  a  severely  strained  credit  structure. 
Since  it  is  precisely  in  times  of  financial  stress  that  "policy 


348         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

loans"  are  sought  most  largely,  and  since  the  marketing  of 
securities  involves  the  withdrawal  of  funds  from  commercial 
banks  by  the  purchasers  of  securities,  it  is  hardly  to  be  denied 
that  the  lack  of  cash  reserves  in  insurance  companies  imposes 
additional  burdens  upon  the  reserves  of  the  banks. 

In  practice,  there  has  been  a  growing  tendency  in  recent 
years  to  keep  both  larger  cash  reserves  and  a  large  amount  of 
readily  marketable  securities.  To  date,  however,  the  insur- 
ance companies  have  shown  little  disposition  to  purchase  short- 
term  paper.  Whether  investments  in  commercial  paper  and 
acceptances  would  serve  to  relieve  the  strain  that  is  now  trans- 
ferred by  the  insurance  companies  to  the  banks  in  time  of  crisis 
is  a  question  which  cannot  be  advantageously  discussed  at 
this  place.* 

VIII.    THE  ECONOMIC  SIGNIFICANCE  OF 
SAVINGS  INSTITUTIONS 

In  the  foregoing  pages  we  have  described  the  different 
types  of  savings  institutions  in  present-day  society  and  con- 
sidered the  chief  problems  arising  in  connection  with  their 
practical  operation.  We  may  now  consider  in  some  detail  the 
economic  services  that  savings  institutions  perform  in  the 
modern  economic  system. 

We  have  already  seen  that  in  the  large  the  function  of  sav- 
ings institutions  is  to  assist  in  the  raising  of  capital  for  modern 
business  enterprise — 'to  bridge  the  gap  between  the  individual 
saver  and  the  borrowing  corporation  or  other  enterprise.  It 
will  be  pertinent  to  inquire  now  whether  savings  institutions 
are  necessary  middlemen;  whether  the  function  ascribed  to 
them  could  not  more  efficiently  be  carried  out  without  such 
financial  intermediaries. 

So  far  as  their  short-time  loans  are  concerned — and  we 
have  found  that  savings  banks,  contrary  to  general  belief,  make 
large  loans  for  working  capital  purposes — it  is  clear  that  it 
would  be  practically  impossible  for  corporations  desiring  to 

'  See  pp.  532-33- 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS  349 

borrow  funds  for  short  periods  of  time  to  make  connections 
with  individual  lenders.  A  financial  intermediary,  which  can 
gather  together  small  savings  from  a  number  of  individuals  and 
turn  them  over  in  large  aggregations  to  corporations  for  short- 
time  uses,  is  an  indispensable  institution.  While  the  savings 
bank  now  performs  an  important  role  in  this  process,  the  com- 
mercial banks  could  doubtless  readily  assume  the  entire 
burden. 

In  the  raising  of  fixed  capital  through  the  sale  of  securities, 
the  case  for  the  savings  institutions  is  more  conclusive,  though 
not  very  obvious.  It  may  be  asked,  Why  should  not  the 
individual  savers  buy  the  securities  directly,  and  thus  receive 
5  or  6  per  cent  instead  of  3  or  4,  as  is  the  case  when  they 
deposit  their  funds  in  savings  institutions  and  allow  the  savings 
banks  to  do  the  investing?  We  shall  find  that  there  are 
several  reasons  why  it  is  better  for  many  people  to  make 
savings  deposits  rather  than  to  invest  in  securities  directly. 

Savings  institutions  facilitate  the  making  of  investments  in 
numeroiis  ways.  First,  there  are  a  great  many  people  whose 
knowledge  of  investment  values  is  so  negligible  that  direct 
investment  in  securities  involves  the  assumption  of  very  great 
risks.  It  is  true  that  they  may  nowadays  avail  themselves  of 
the  advice  and  counsel  of  investment  bankers;  but  many 
people  are  not  aware  of  this  opportunity,  or,  if  they  are  aware 
of  it,  they  are  unwilling  or  unable  to  establish  connections  with 
an  investment  banking  house. 

Second,  the  savings  of  a  very  large  percentage  of  people  are 
too  smaU  in  amount  to  make  direct  investments  in  securities 
through  the  established  channels  practicable.  While  in  recent 
years  bond  houses  have  been  cultivating  the  small  investor 
increasingly  and  are  now  offering  "baby  bonds"  and  "partial 
payment"  plans  as  a  means  of  inducing  investments  of  small 
amounts,  they  still  remain  essentially  institutions  which  serve 
the  upper  rather  than  the  lower  strata  of  investors.  One  should 
ordinarily  have  several  hundred  dollars  of  savings  before 
attempting  to  invest  in  securities.  Savings  institutions,  how- 
ever, do  reach  the  smallest  accumulations;  they  gather  in  even 


35©         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  penny  savings  of  society  and  make  them  available  in  larger 
aggregations  for  the  purposes  of  business. 

Third,  unless  one  has  a  considerable  volume  of  savings,  the 
problem  of  safekeeping  is  a  deterrent  to  bond  investments.  A 
safety  deposit  box  costs  from  three  to  five  dollars  a  year;  and  if 
one  has  only  a  hundred-dollar  bond,  the  interest  is  largely 
absorbed  in  paying  for  the  safety  box.  The  savings  bank 
deposit,  however,  is  taken  care  of  by  the  bank. 

Fourth,  the  savings  bank  method  of  effecting  savings  is 
generally  more  convenient  than  making  direct  investments  in 
bonds.  Savings  institutions  are  usually  located  conveniently 
for  the  investor  of  small  means  and  are  kept  open  for  business 
at  hours  which  facilitate  the  making  of  deposits.  Moreover, 
the  making  of  a  deposit  is  simplicity  itself — merely  handing  the 
funds  through  a  window  and  receiving  an  entry  in  a  deposit 
book.  The  postal  savings  banks,  as  we  have  seen,  offer  still 
greater  conveniences  in  this  connection. 

Fifth,  a  deposit  in  a  savings  bank  can  usually  be  more  easily 
recalled  in  case  of  need  than  an  investment  in  bonds.  While 
this  is  not  so  true  in  the  case  of  large  investments,  where  the 
investors  maintain  close  relations  with  bond  houses  and  select 
their  securities  with  a  view  to  ready  marketability,  it  is  practi- 
cally always  true  of  small  investments  in  securities.  As  we 
have  seen,  a  savings  bank  deposit  is  ordinarily  payable  on 
demand  and  payable  in  full.  A  bond  of  small  denomination 
very  frequently  cannot  be  quickly  disposed  of;  and  even  bonds 
of  large  denomination  may  be  marketed  at  a  given  time  only  at 
a  loss. 

Savings  banks  and  insurance  companies  lessen  the  risks  of 
investment.  More  important  than  any  of  the  foregoing  services 
that  are  performed  by  savings  institutions  is  the  fact  that  they 
enable  one  to  lessen  the  risks  of  investment.  No  matter  how 
excellent  one's  knowledge  of  the  value  of  securities  may  be, 
there  is  always  some  risk  of  loss  with  any  given  security.  And, 
in  accordance  with  the  theory  of  probability,  the  percentage  of 
loss  is  always  less,  the  wider  the  distribution  of  investments. 
This  is  simply  an  application  of:  the  old  adage,  "Don't  put  all 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS         351 

your  eggs  in  one  basket."  By  virtue  of  its  very  large  invest- 
ments, the  savings  bank  can  always  distribute  its  risks  widely; 
while  an  individual  can  do  so  only  if  he  is  comparatively 
wealthy. 

The  mutual  savings  institutions  are,  in  reality,  nothing  but 
a  device  for  pooling  the  investments  and  the  losses  of  the 
depositors,  thereby  lessening  the  risks  assumed  by  each.  The 
stock  savings  bank  accomplishes  the  same  result  by  a  more 
roundabout  process.  Individuals  turn  their  funds  over  to  the 
bank  and  receive  the  promise  of  the  bank  to  pay  them  in  full; 
the  bank  diversifies  its  investments  as  much  as  possible  in 
order  to  reduce  the  chances  of  loss.  The  resources  contributed 
by  the  shareholders  of  the  bank  may  also  be  drawn  upon  to 
prevent  loss  to  depositors.  The  risks  of  loss  to  the  individual 
are  thus  very  greatly  lessened. 

The  large  insurance  companies  perhaps  present  the  best 
examples  of  widely  diversified  risks.  By  virtue  of  their  very 
great  size,  these  companies  are  enabled  to  invest  in  bonds  and 
securities  of  any  number  of  corporations  and  in  real  estate  mort- 
gages on  farms  throughout  the  length  and  breadth  of  the 
United  States,  not  to  mention  foreign  countries.  It  is  thus 
impossible  for  a  large  company  to  suffer  a  total  loss,  except  in 
the  event  of  a  complete  destruction  of  the  existing  economic 
order.  A  very  small  percentage  of  loss  on  the  total  investments 
is  absolutely  assured.  In  a  word,  every  depositor  in  a  large 
savings  institution,  and  every  person  insured  in  a  large  insur- 
ance company,  is  in  effect  a  part-owner  of  all  the  corporations, 
farms,  etc.,  whose  securities  and  mortgages  have  been  purchased 
by  the  bank  or  insurance  company,  and  his  potential  losses  are 
thereby  reduced  to  a  negligible  minimum. 

A  further  word  is  in  point  with  reference  to  the  savings  that 
are  effected  through  life  insurance  companies.  When  one  takes 
out  life  insurance,  he  places  a  premium,  albeit  a  negative 
premium,  upon  making  additional  savings;  for  if  one  does  not 
meet  his  payments  as  they  mature,  he  stands  to  lose  the  savings 
that  he  has  previously  made.  Since  a  large  percentage  of 
people  are  so  constituted  that  they  cannot  resist  the  impulse  to 


352         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

spend  unless  they  have  a  heavy  penalty  hanging  over  their 
heads,  savings  through  insurance  is  a  most  useful  device  for  com- 
pelling people  to  make  provision  for  the  rainy  day. 

In  the  light  of  these  considerations  it  is  clear  that  the  savings 
banks  do  perform  important  services  as  middlemen  in  the  pro- 
cess of  bringing  borrowers  and  lenders  together.  The  stock 
savings  banks  and  the  insurance  companies  are  accordingly 
entitled  to  the  difference  between  the  interest  which  they  pay 
on  deposits  and  the  interest  which  they  receive  from  their 
loans  and  investments  in  securities.  The  various  conveniences 
of  savings  institutions,  and  the  reduction  of  risks  that  is  afforded 
by  virtue  of  the  wide  distribution  of  loans  and  investments, 
more  than  compensate  the  individual  saver  for  the  lower  rate 
of  return  which  he  receives  when  he  invests  in  savings  insti- 
tutions than  when  he  invests  in  bonds.  It  may  be  observed, 
moreover,  that  no  one  is  compelled  to  make  investments 
through  savings  institutions;  if  one  prefers,  he  can  secure  the 
higher  rate  of  interest  by  investing  in  securities  directly. 

Finally,  the  savings  institutions,  like  the  bond  houses, 
assist  to  some  extent  in  directing  the  flow  of  industrial  energy. 
This  is  particularly  the  case  with  the  stock  savings  bank  of  the 
south  and  west,  whose  investments  are  not  circumscribed  by 
legislation,  as  is  usually  the  case  with  the  mutual  institutions 
of  the  east.  Such  savings  institutions,  as  we  have  seen,  invest 
directly  in  the  securities  of  local  and  other  enterprises  and  they 
make  short-time  loans  to  corporations  and  businesses,  both  at 
home  and  in  other  centers.  In  making  these  direct  invest- 
ments the  savings  bank  officials  must  pass  judgment  upon  the 
honesty  and  integrity  of  the  management  and  upon  the  ability 
of  the  borrowing  enterprise  to  pay  the  loans  at  maturity.  Like 
the  bond  house  analysts,  they  hold  a  veto  power  over  the 
expenditure  of  funds  for  any  given  purpose;  and  in  proportion 
as  the  judgment  of  savings  bank  managers  is  superior  to  that 
of  the  rank  and  file  of  savings  depositors,  the  distribution  of 
industrial  energy  is  thus  more  efficiently  directed. 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS  353 

QUESTIONS  FOR  DISCUSSION 

I.      THE  DIFFERENT  TYPES   OF  SAVINGS  INSTITUTIONS 

1.  What  is  the  essential  difference  between  stock  and  mutual  sav- 
ings banks  ? 

2.  How  does  the  guaranty  savings  bank  differ  from  the  mutual 
institutions?  Has  it  any  advantages  over  either  the  stock  or 
the  mutual  bank  ? 

3.  Which  class  of  savings  banks  is  the  more  numerous?  Which 
does  the  larger  volume  of  business  ? 

4.  How  do  you  account  for  the  geographical  distribution  of  mutual 
and  stock  savings  institutions  ? 

5.  If  you  were  organizing  a  savings  institution,  which  type  should 
you  choose  ? 

6.  Do  you  see  any  good  reason  why  a  commercial  bank  should  not 
accept  savings  deposits  ?  Do  you  see  any  reason  why  the 
accounts  of  the  savings  department  should  be  kept  distinct 
from  those  of  the  commercial  department  ? 

7.  Do  you  think  that  the  postal  savings  institutions  have  filled  a 
genuinely  important  need  ? 

8.  Were  the  objections  to  the  development  of  the  postal  savings 
institutions  well  founded  ? 

9.  What  provisions  of  the  postal  savings  law  are  designed  to  elimi- 
nate competition  with  savings  banks  ? 

10.  Does  it  seem  to  you  probable  that  the  postal  savings  institutions 
have  on  the  whole  been  a  source  of  gain  to  the  banks  ?  If  so, 
how  do  you  account  for  the  failure  of  bankers  to  appreciate 
this  in  advance? 

11.  What  is  the  purpose  of  permitting  investments  in  postal  savings 
bonds  ? 

12.  What  is  the  purpose  of  authorizing  the  president  of  the  United 
States,  at  his  discretion,  to  require  the  board  of  trustees  to  invest 
all  or  any  part  of  the  postal  savings  funds  in  United  States 
bonds  and  securities  ? 

13.  What  is  the  purpose"  of  requiring  the  depository  banks  to  put  up 
bonds  ? 

14.  How  large  is  the  reserve  of  postal  savings  banks  ? 

15.  Is  there  need  for  additional  or  better  savings  facilities  in  the 
communities  with  which  you  are  familiar  ? 


3S4         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

n.      THE  OPERATION  AND  MANAGEMENT  OF  SAVINGS  BANKS 

i6.  Define  capital  stock;  surplus;  undivided  profits;  shareholders' 
liabilities;  balance  sheet. 

17.  What  is  the  net  worth  of  the  bank  whose  statement  appears  on 
page  331  ? 

18.  Indicate  what  changes  in  the  items  of  the  balance  sheet  of  a 
stock  savings  bank  would  occur  as  a  result  of  the  following 
transactions : 

Note. — Method  to  be  used:  The  purpose  in  this  exercise  is 
merely  to  show  what  assets  or  liabilities  are  increased  or  decreased 
as  a  result  of  each  operation.  It  wiU  facilitate  matters,  therefore, 
if  the  student  merely  uses  the  plus  or  minus  symbol  to  indicate  a 
change.  For  example,  if  deposits  have  been  received,  one 
should  note  that  fact  by  marking  on  the  liabilities  side  deposits 
+  $1,000;  or  if  cash  has  been  paid  out,  one  should  mark  on  the 
assets  side  cash  —  $1,000. 

o)  The  bank  receives  $10,000  composed  of  the  following  items: 
(i)  Specie,  $100 

(2)  Paper  currency,  $100 

(3)  Checks  on  commercial  banks,  $5,000 

(4)  Bank  drafts,  $3,000 

(s)  Cashier's  checks,  $1,800 

b) 

(i)  It  makes  investments  of  $20,000  in  bonds 

(2)  It  makes  $10,000  of  loans  secured  by  real  estate 

(3)  It  buys  loo  U.S.  liberty  bonds  at  $86 .  50 

(4)  It  buys  100  railroad  bonds  at  62I 

c)  The  bank  deposits  $10,000  in  a  commercial  bank 

d)  The  bank,  which  has  a  capital  stock  of  $100,000,  a  surplus 
of  $50,000,  and  an  undivided  profits  account  of  $15,000 
declares  a  semiannual  dividend  of  4  per  cent. 

19.  A  mutual  savings  institution  with  deposits  of  $100,000  has 
earnings  for  the  half-year  of  $4,500.  At  what  rate  may  a  divi- 
dend be  declared,  and  what  would  determine  how  much  each 
person  entitled  to  the  dividend  would  receive  ? 

20.  Compare  the  percentage  of  loans  to  investments  in  securities  in 
both  stock  and  mutual  savings  banks. 

21.  Which  way  of  using  the  funds  of  a  savings  bank  would  you  con- 
sider preferable:  in  purchasing  bonds  and  stock;  or  in  making 
loans? 


THE  FUNCTIONS  OF  SAVINGS  INSTITUTIONS         355 

22.  Draw  up  a  list  of  the  types  of  loans  that  you  should  consider  it 
safe  for  a  savings  bank  to  make. 

23.  Criticize  the  provisions  of  the  New  York  savings  bank  law. 

24.  Draw  up  a  negative  statement  showing  the  types  of  loans  and 
investments  that  cannot  be  engaged  in  under  the  New  York  law. 
Do  you  think  it  necessary  to  prohibit  all  such  loans  and  invest- 
ments ? 

25.  What  is  the  purpose  of  keeping  a  cash  reserve  ?  What  factors 
win  govern  the  amount  of  such  reserve  that  must  be  carried  ? 

26.  How  much  is  the  average  reserve,  as  shown  by  the  combined 
financial  statements  given  above,  of  the  stock  and  of  the  mutual 
savings  banks  of  the  United  States  ? 

27.  Do  you  think  savings  banks  shoxUd  attempt  always  to  pay 
deposits  on  demand  ? 

28.  Why  have  savings  banks  tended  more  and  more  to  make  short- 
time  loans  for  working  capital  purp>oses  ? 

29.  Should  savings  banks  adopt  the  principle  of  "safety  first,"  or 
should  they  have  in  mind  other  things  as  well?    If  so,  what? 

30.  If  savings  banks  no  longer  require  the  notice  of  withdrawal, 
ought  they  not  to  be  subject  to  the  same  reserve  regulation  as 
commercial  banks  ? 

31.  How  does  a  mutual  bank  make  its  profits?  How  does  a  stock 
institution  make  profits  ? 

m.      INSURANCE  COMPANIES  AS  SAVINGS  INSTITUTIONS 

32.  Show  how  life  insurance  companies  promote  savings,  even  when 
the  purpose  of  taking  out  insurance  is  merely  to  secure  pro- 
tection. 

33.  Draw  up  a  statement  showing  what  t3T)es  of  business  life  insur- 
ance companies  assist  most  in  financing. 

34.  Do  the  insurance  companies  promote  the  raising  of  working 
capital  as  well  as  fixed  capital  ? 

35.  What  is  the  purpose  of  policy  loans  ?  Enumerate  as  many  piu:- 
poses  as  possible  for  which  one  might  wish  to  borrow  on  a  life 
insurance  policy. 

36.  It  is  said  that,  because  of  the  practice  of  loaning  on  policies  on 
demand,  the  insurance  companies  should  be  required  to  keep  a 
cash  reserve.    Do  you  agree  ? 

37.  Under  what  conditions  would  the  greatest  volume  of  life  insur- 
ance policy  loans  be  demanded  ?    What  is  the  result  of  this  ? 


356         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

IV.      ECONOMIC  SIGNIFICANCE   OF   SAVINGS   INSTITUTIONS 

38.  Draw  up  a  statement  indicating  what  groups  of  people  find  sav- 
ings institutions  an  advantage. 

39.  Do  you  think  savings  institutions  are  as  important  now  as  before 
the  development  of  the  investment  banks  ? 

40.  Will  savings  institutions  always  be  necessary  as  a  means  of  dis- 
tributing the  risks  of  investors  of  small  means  ? 

41.  In  which  t5T)e  of  savings  bank,  stock  or  mutual,  do  you  think 
the  risks  to  the  individual  saver  are  smaller  ? 

42.  Do  you  think  it  is  correct  to  say  that  the  principal  difference 
between  a  savings  bank  and  a  commercial  bank  is  that  one  pro- 
vides capital  for  long-time  permanent  needs  and  the  other 
provides  the  current  funds  required  by  business  enterprises  ? 

43.  Can  you  think  of  any  good  reason  why  savings  banks  should  be 
organized  as  specialized  institutions  making  loans  and  invest- 
ments for  only  fixed  capital  purposes  ? 

44.  What  is  the  distinctive  advantage  of  the  insurance  company  in 
promoting  savings  ? 

45.  Would  you  as  soon  do  your  savings  through  an  insurance 
company  as  through  a  savings  bank?  How  does  the  rate  of 
return  compare  ?    How  do  the  risks  of  loss  compare  ? 

46.  Would  you  favor  the  abolition  of  savings  banks  on  the  ground 
that  their  fimctions  can  be  as  well  performed  by  insurance  com- 
panies and  bond  houses  ? 

REFERENCES  FOR  FURTHER  READING 

Kniffin,  William  H. :  The  Savings  Bank  and  Its  Practical  Work, 
1916. 

Hamilton,  James  H.:  Savings  and  Savings  Institutions,  1908. 

Notes  on  the  Postal  Savings  Bank  Systems  of  the  Leading 
Countries:  National  Monetary  Commission,  1910. 

Kemmerer,  Edwin  W.:  Postal  Savings,  1917. 

Savings  Banks  Monthly  Journal. 


CHAPTER  XIX 

THE  PRACTICAL  OPERATIONS  OF  THE 
COMMERCIAL  BANK 

With  this  chapter  we  pass  to  a  consideration  of  the  raising 
of  the  working,  or  operating,  capital  required  by  modem  business 
enterprise.  By  reference  to  the  charts  on  pages  134  and  136 
it  will  be  seen  that  individual  firms,  partnerships,  and  cor- 
porations borrow  their  working  capital  largely  from  com- 
mercial banks,  using  promissory  notes  and  bills  of  exchange  as 
evidences  of  the  credit  obligations  involved/  The  charts  also 
indicate  that  to  some  extent  this  borrowing  from  commercial 
banks  is  done  through  commercial  paper  houses  and  com- 
mercial credit  or  discount  companies,  which  act  as  intermediaries 
in  the  process.  The  remaining  chapters  of  the  volume  will  be 
largely  devoted  to  a  discussion  of  the  functions  of  the  financial 
institutions  that  are  associated  with  the  raising  of  working 
capital. 

As  has  been  suggested  at  various  points  in  the  preceding 
chapters,  however,  commercial  banks  also  play  an  important 
role  in  connection  with  the  raising  of  fixed  capital.  Indeed, 
the  charts  in  chapter  x  are  designed  to  indicate  that  the  com- 
mercial banks,  including  the  Federal  Reserve  System,  occupy 
a  position  of  paramount  importance  in  the  entire  financial 
structure.  In  studying  the  commercial  banking  system, 
therefore,  it  will  be  our  purpose  to  reveal  the  manifold  relations 
of  commercial  banking  with  the  other  parts  of  the  financial 
system;  and  especially  to  show  its  significance  to  the  general 
economic  organization  of  modern  industrial  society.  Several 
chapters  will  be  required  to  work  out  these  larger  aspects  of 
commercial  banking.    The  present  chapter  is  designed  to  lay 

*  See  also  the  chart  on  p.  650  in  Part  III. 
357 


358         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  basis  for  an  analysis  of  the  significance  of  commercial 
banking  by  outlining  the  practical  organization  and  operations 
of  an  individual  commercial  banking  institution. 

I.    CLASSIFICATION  OF  COMMERCIAL  BANKS 

Before  considering  the  nature  of  commercial  banking 
operations,  it  should  be  pointed  out  that  commercial  banks 
are  classified  into  national,  state,  and  private  institutions.  A 
national  bank,  as  the  name  indicates,  receives  its  charter  from 
the  federal  government;  while  a  state  bank  receives  its  charter 
from  the  particular  state  in  which  it  is  located.  It  may  be 
recalled  that  trust  companies,  chartered  under  state  laws, 
usually  operate  commercial  banking  departments.  Private 
banks,  as  the  name  implies,  are  unchartered  institutions, 
conducting  their  operations  without  specific  grant  of  authority. 
They  have  usually  been  subject  only  to  those  legal  regulations 
which  surround  other  private  businesses;  although  in  recent 
years  most  state  laws  have  come  to  require  that  private 
banks  submit  to  the  same  supervision  as  incorporated  insti- 
tutions. 

The  existence  of  both  national  and  state  banks  is  merely 
the  result  of  our  dual  form  of  government.  And  it  would  be  a 
distinction  without  significance,  were  it  not  for  the  fact  that 
the  regulations  imposed  on  banking  operations  vary  somewhat 
in  the  different  states  and  that  state  legislation  is  typically 
somewhat  less  stringent  than  that  of  the  federal  government. 
While  the  nature  of  these  regulations  and  the  essential  differ- 
ences may  best  be  reserved  for  subsequent  discussion,'  it 
will  be  of  interest  to  observe  at  this  place  the  relative  number, 
size,  and  rate  of  growth  of  national  and  state  banks.  The 
national  banking  system  was  inaugurated  during  the  Civil  War 
by  an  act  of  1863,  with  amendments  in  1864.  The  following 
diagrams  indicate  the  development  of  banking  in  the  United 
States  from  1867  to  1918: 

'  For  the  nature  of  commercial  bank  regulations  see  chap,  zziv  below. 


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PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK     361 

IT.    INCIDENTAL  SERVICES  OF  COMMERCIAL 
BANKS 

Commercial  banks  perform  a  great  variety  of  services, 
some  of  them  being  in  the  nature  of  incidental  conveniences  to 
individuals  and  businesses,  and  others  of  fundamental  impor- 
tance from  the  standpoint  of  the  general  economic  system.  The 
less  significant  ones  may  conveniently  be  disposed  of  at  this 
place  once  and  for  all. 

First,  commercial  banks  serve  as  places  of  security  for  the 
keeping  of  funds  that  are  temporarily  not  needed  by  their 
owners.  Having  well-equipped  vaults,  and  being  managed 
(with  rare  exceptions)  by  men  of  integrity,  the  risk  of  loss  to 
the  owner  from  fire,  theft,  or  other  contingencies  is  very  greatly 
minimized. 

Second,  commercial  banks  serve  as  money  changers.  In 
accommodating  each  individual  customer  with  the  kinds  and 
denominations  of  money  desired,  they  supply  the  community 
as  a  whole  with  the  forms  of  currency  best  adapted  to  its 
commercial  needs.  They  perform  this  function  in  part  through 
the  issue  of  their  own  notes,  and  in  part  by  acting  as  agencies 
of  the  government  for  its  issues  of  paper  currency,  subsidiary 
silver,  and  minor  coins. 

Third,  through  the  system  of  checks,  or  deposit  currency, 
the  commercial  banks  make  possible  the  use  of  a  form  of  currency 
which  is  a  particularly  convenient  means  of  payment.  A 
check  may  be  written  for  odd  amounts,  as  well  as  for  even 
figures.  This  is  a  great  economy  of  time;  for  it  is  a  very 
simple  matter  to  write  a  check  for  $27,965.29,  whereas  to 
coimt  that  amount  of  money,  even  if  large  denominations  are 
used,  requires  no  little  time;  and  the  risk  of  error  in  counting 
is  at  the  same  time  of  course  eliminated.  The  use  of  checks 
rather  than  specie  in  the  settlemjnt  of  large  transactions 
obviates  the  necessity  of  weighing  and  testing  the  fineness  of 
metallic  currency;  and,  similarly,  it  greatly  lessens  the  possible 
abrasion  of  metallic  money.  Both  checks  and  bank  notes 
are  also  inexpensive  media  of  exchange. 


362         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Fourth,  the  use  of  checks  greatly  reduces  the  risks  of 
monetary  transactions.  Unless  indorsed  in  blank,  checks  are 
good  only  in  the  hands  of  the  person  to  whose  order  they  are 
drawn;  and  accordingly  the  risks  from  possible  loss  or  theft 
are  virtually  negligible. 

Fifth,  the  check  system  greatly  facilitates  the  keeping  of 
accounts  by  individuals.  Indeed,  the  banker  may  virtually 
take  over  the  individual's  bookkeeping;  for  if  a  person  deposits 
with  his  bank  all  the  money  he  receives  in  a  year  and  makes  all 
his  payments  by  check,  he  always  has  an  accurate  record  of  his 
financial  status.  The  statement  rendered  at  the  end  of  each 
month  presents  a  record  of  all  funds  received  and  all  funds 
paid  out,  and  shows  the  balance  on  hand.  The  canceled 
checks,  moreover,  serve  as  valid  receipts  for  the  payment  of 
obligations. 

Sixth,  the  commercial  banks  perform  important  services 
for  individuals  in  transmitting  money  from  one  part  of  the 
country  to  another.  Upon  receipt  of  the  necessary  funds, 
the  bank  draws  a  draft  upon  a  correspondent  bank  in  the  city 
where  the  payment  is  to  be  made,  asking  it  to  pay  the  designated 
party  a  specified  amount  of  money.  Settlements  between  the 
two  banks  may  be  made  only  periodically;  and  by  virtue  of 
the  machinery  of  domestic  exchange  already  discussed  (see 
pp.  1 1 5- 1 6  above),  cash  seldom  moves  in  the  transmission  of 
such  funds.  The  risk  of  loss  or  theft  is  of  course  reduced  to  a 
minimum,  and  the  use  of  specie  is  economized  by  lessening  the 
amount  that  needs  to  be  in  transit.  Banks  perform  a  similar 
service  for  individuals  in  cashing  checks  which  are  drawn  on 
banks  in  other  localities.  The  work  of  banks  in  effecting 
international  exchanges  should  be  recalled  in  this  connection. 

Seventh,  bankers  act  as  collection  agents  for  their  customers, 
for  promissory  notes,  drafts,  coupons,  etc.  At  or  before  matur- 
ity, the  individual  turns  his  credit  instrument  or  claim  over  to 
the  bank  for  collection.  Upon  receiving  the  funds,  through  its 
messenger  service  or  by  way  of  correspondent  banks,  the  bank 
credits  the  individual's  account  with  the  amount  received. 
If  the  obligations  are  not  paid,  the  individual  is  notified  and 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      363 

the  bank  officials  are  in  a  position  to  serve  as  witnesses  in  proof 
that  the  claim  has  been  duly  presented. 

Eighth,  bankers  undoubtedly  exert  a  very  great  influence 
in  the  promotion  of  financial  integrity  and  business  ability. 
In  the  protection  of  their  own  interests  banks  always  pay 
close  attention  to  the  moral  character  and  the  ability  of  the 
parties  with  whom  they  deal.  They  inquire  whether  they  be 
honest  or  tricky,  industrious  or  idle,  able  or  inefficient,  prudent 
or  speculative,  thrifty  or  prodigal.  Since  the  banker  is  used 
as- a  continual  reference  to  one's  "respectability"  and  to  one's 
honesty  and  punctuality  in  meeting  pecuniary  engagements, 
it  is  necessary  for  individuals  always  to  have  regard  for  such 
considerations  and  to  qualify  as  well  as  may  be  for  the  good 
opinion  of  the  banking  fraternity. 

These  various  services  are  only  the  simpler  ones  performed 
by  the  commercial  banks.  Their  functions  in  connection 
with  the  issue  of  bank  notes  and  the  creation  of  bank  credit 
or  deposit  currency  remain  for  later  consideration.  It  need 
merely  be  stated  here  that  it  is  these  functions,  particularly 
the  latter,  in  modern  times,  which  constitute  the  distinguishing 
characteristics  of  commercial  banking;  they  are  what  give  it 
its  paramount  importance  in  the  general  economic  organization 
of  the  modern  world. 

III.     ANALYSIS  OF  COMMERCIAL  BANKING 
OPERATIONS 

The  nature  of  commercial,  like  that  of  savings  bank  opera- 
tions, may  best  be  revealed  through  an  analysis  of  a  balance 
sheet  or  financial  statement  of  condition.  Indeed^  only  by 
employing  the  technical  terms  used  in  commercial  banking  and 
by  working  through  in  concrete  fashion  on  a  balance  sheet  the 
effects  of  practical  banking  operations,  can  one  obtain  a  clear 
understanding  of  the  nature  of  commercial  banking.  The  two 
financial  statements  below— the  one  of  a  very  large  national 
bank,  and  the  other  of  a  relatively  small  state  institution — will 
be  found  to  furnish  most  of  the  data  necessary  to  the  analysis 
which  follows: 


364         THE  FINANCIAL  ORGANIZATION  OP  SOCIETY 

CONTINENTAL  AND  COMMERCIAL  NATIONAL  BANK 
OF  CHICAGO^ 

RESOURCES 

Loans  and  discounts' $216,489,390.61 

Overdrafts,  unsecured 32,959.47 

Customers'  liability  on  account  of  drafts  paid  under 

letters  of  credit  for  which  this  bank  has  not 

been  reimbursed 3.623.38 

Customers'  liability  on  account  of  "acceptances".  6,057,234. 50 

United  States  Government  securities: 

a)  Deposited  in  United  States 
Treasury  to  secure  note 
circulation       ....     $       50,000.00 

b)  Pledged   to   secure    United 

States  deposits  .      .  355,000.00 

c)  Pledged  to  secure  state 
or  other  deposits  or  bills 

payable 22,542,500.00 

d)  Unpledged       ....  727,476.02 

23»674,976.o2 

United  States  certificates  of  indebtedness   .     .     .  2,181,610.00 

Other  bonds,  securities,  etc 15,712,978.22 

Stocks  other  than  Federal  Reserve  bank  stock      .  746,233.80 

Stock  of  Federal  Reserve  bank 1,020,000.00 

Securities  bought  under  agreeinent  to  resell  .     .  1,071,906.98 

Equity  in  banking  house 6,000,000.00 

Exchanges  for  the  clearing  house 15,147,311.99 

Checks  on  out-of-town  banks 733,163.34 

Items  with  Federal  Reserve  bank  in  process  of  col- 
lection (not  available  as  reserves)  ....  3,733,152.27 
Lawfvd  reserves  with  Federal  Reserve  banks    .     .  31,598,419.05 
Cash  in  vaults  and  due  from  national  banks    .      .  42,309,635.  51 

Due  from  state  and  private  banks 35,487,907.63 

Redemption  fund  with   United  States  Treasury 
($2,500)  and  due  from  United  States  Treasury 

($9,ooc)— total 11,500.00 

Other  assets 318,184.13 

Total $402,330,186.90 

'  Report  of  condition  in  Nov.  17,  1919. 

*  $25,361,992.36  of  other  loans  have  been  rediscounted  with  the  Federal 
Reserve  bank  of  Chicago.  This  involves  a  contingent  liability  to  this  bank 
as  isdorser. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      365 

LIABIUXIES 

Capital  Stock  paid  in $  21,500,000,00 

Surplus 12,500,000.00 

Undivided  profits 4,479,734-73 

Reserved  for  taxes  accrued 2,168,664.93 

Circulating  notes  outstanding 50,000.00 

Due  to  national  banks 65,384,485.59 

Due  to  state  and  private  banks 65,870,828.70 

Certified  checks 1,653,461.55 

Cashier's  checks  outstanding 1,806,298.51 

Individual  deposits  subject  to  check      ....  183,893,262.19 

Certificates  of  deposit  due  in  less  than  thirty  days  5,885,634.47 
Time  certificates  of  deposit  (payable  after  thirty 

days) 772,156.80 

United  States  deposits 4,284,439.15 

Dividends  unpaid 9,763.00 

Bills  payable  with  Federal  Reserve  banks  .  .  .  22,450,000.00 
Letters  of  credit  and  travelers'  checks  sold  for  cash 

and  outstanding 209,458.71 

Acceptances 6,057,234.50 

Other  liabilities 3,354,764-07 

Total $402,330,186.90 


MAYWOOD  (ILLINOIS)  STATE  BANK» 

RESOURCES 

Loans  and  discounts $    720,871.40 

Overdrafts 21.89 

Bonds  and  securities 260,568.95 

Real  estate 25,880.00 

Due  from  banks  and  bankers 172,879.85 

Exchanges  for  clearing  house     . 3,010.12 

Checks  and  other  cash  items 2,113.79 

Cash  on  hand 50,589.51 

Accounts  receivable 1,112.05 

Total $1,237,047.56 

'  Jleport  of  condition  g.t  t|ie  close  of  business  November  17,  1919. 


366         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

LIABILITIES 

Capital  stock  paid  in $    100,000 .  00 

Surplus  fund 85,000.00 

Undivided  profits 19,213.80 

Dividends  unpaid 42.00 

Time  deposits,  savings 464,425.23 

Time  deposits,  certificates 13,417.15 

Demand  deposits,  individual 470,688.78 

Certified  checks 3)3S8.4S 

Cashier's  checks  outstanding i3>209.73 

Due  to  other  banks 54,145.84 

Reserved  for  taxes  and  interest 5,684.77 

Postal  savings  fund 7,861.81 

Total $1,237,047.56 

Following  the  method  used  in  the  chapter  on  savings 
institutions,  let  us  organize  a  commercial  bank  and  carry 
through  a  series  of  practical  operations.  We  may  start  by 
issuing  10,000  shares  of  stock  which  sell  at  $110  per  share. 
After  spending  $100,000  for  a  bank  building  and  the  necessary 
furniture  and  fixtures,  the  preliminary  statement  of  the  bank 
would  stand  as  follows: 

RESOURCES  LIABILITIES 

Cash $1,000,000       Capital  stock     .     .  $1,000,000 

Banking  house,  fur- 
niture, and  fixtures        100,000       Surplus   ....        100,000 

Commercial  bank  deposits  are  mainly  a  result  of  loaning 
operations.  The  essential  difiference  between  commercial  and 
savings  banking  operations  may  best  be  made  clear  if  we  con- 
sider at  the  outset  the  loan  item  on  the  assets  side  of  the  balance 
sheet,  together  with  the  deposit  item  on  the  liabilities  side. 
When  the  savings  bank  was  ready  for  business,  we  saw  that 
individuals  brought  funds  to  the  bank  for  deposit,  thus  giving 
rise  to  deposit  accounts  on  the  liabilities  side  of  the  statement. 
Commercial  banks  also  receive  deposits  of  cash;  but  the 
striking  characteristic  of  commercial  banking  will  be  seen  most 
clearly  if  we  first  assume  that  when  this  bank  which  we  have 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      367 

organized  opens  its  doors  for  business  it  does  not  solicit  deposits 
of  cash,  but  merely  states  in  its  preliminary  announcement 
that  it  is  in  a  position  to  make  loans  to  manufacturers, 
merchants,  etc. 

Suppose  now  that  a  number  of  business  men  come  to  the 
bank  for  loans  with  which  to  conduct  their  business  operations. 
Mr.  A  is  given  a  loan  of  $100,000  for  four  months,  the  interest 
at  6  per  cent  being  deducted  in  advance.  What  changes, 
immediately  speaking,  would  this  cause  on  the  bank's  balance 
sheet  ?  On  the  assets  side  an  entry  would  be  made,  under  the 
heading  "Loans  and  discounts, "  of  $100,000.  Mr.  A  is  entitled 
to  withdraw  from  the  bank  $98,000,  the  other  $2,000  being 
the  amount  of  the  interest  deducted  in  advance.  A  may  with- 
draw the  $98,000  in  actual  cash  if  he  desires;  or  if  he  finds  it  more 
convenient,  he  may  ask  the  bank  to  enter  it  to  his  credit  as  a 
deposit  account  against  which  he  may  write  checks  at  his 
convenience.  In  the  great  majority  of  instances,  indeed  almost 
universally  nowadays,  when  business  men  borrow  from  banks 
they  take  the  entire  amount  in  the  form  of  a  checking  account, 
except  of  course  insofar  as  they  may  require  pay-roll  or  till 
money.  Let  us  assume  in  this  case  that  the  entire  amount  is 
taken  in  the  form  of  a  checking  account.  The  balance  sheet, 
for  the  moment,  will  then  stand  as  follows: 

RESOURCES  '  LIABILrriES 

Loans  and  discounts    $    100,000      Capital  stock     .     .  $1,000,000 
Banking  house,  fur- 
niture, and  fixtures         100,000      Surplus    ....        100,000 

Cash 1,000,000      Deposits       .     .     .         98,000 

Undivided  profits    .  2,000 


Total      .     .     .     $1,200,000  Total     .     .     .  $1,200,000 

It  is  thus  apparent  that  this  commercial  bank  has  created  a 
deposit  account  without  the  receipt  of  any  actual  cash — merely 
as  a  result  of  a  loan  operation.  But  suppose  now  that  Mr.  A 
writes  a  check  for  $98,000  in  favor  of  Mr.  X.  Suppose,  also, 
that  Mr.  X,  another  business  man  in  this  community,  desires 
to  be  a  customer  of  this  bank.    Upon  receipt  of  the  check  Mr.  X 


368         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

presents  it  at  the  bank  and  asks  that  an  account  be  opened  in 
his  name,  with  the  $98,000  credited  to  the  account.  The 
result  of  this  operation,  so  far  as  deposits  are  concerned,  would 
be  merely  to  deduct  $98,000  from  Mr.  A's  account  and  add 
$98,000  to  Mr.  X's  account.  The  total  deposits  in  the  bank 
would  be  unchanged.  While  X's  deposit  account  came  over 
the  counter  in  the  form  of  a  check  presented  to  the  bank,  it  is 
obvious  that  it  is  still  indirectly  the  result  of  the  loan  that  was 
made  to  A.  No  cash  has  as  yet  been  brought  to  the  bank; 
nor  has  any  been  paid  out. 

Mr.  X,  however,  now  has  the  right  to  withdraw  $98,000 
in  cash  from  the  bank,  if  he  so  desires;  but  since  it  is  more 
convenient  in  the  great  majority  of  instances  to  meet  his 
obligations  by  means  of  checks,  he  will  probably  have  occasion 
to  withdraw  little,  if  any,  cash.  Let  us  assume  that  Mr.  X 
writes  four  checks  of  $24,500  each  to  M,  N,  O,  and  P  respec- 
tively. M,  N,  O,  and  P,  desiring  to  do  business  with  this 
bank,  in  turn  present  the  checks  for  deposit.  The  net  result  is 
to  leave  the  total  of  deposits  unchanged;  though  instead  of 
being  credited  to  X,  the  deposits  are  now  credited  to  the  accounts 
of  M,  N,  O,  and  P, — $24,500  to  each.  In  their  turn  M,  N,  O, 
and  P  may  write  checks  against  their  deposit  accounts,  for 
varying  amounts  and  to  the  order  of  various  people.  If  all 
the  people  receiving  such  checks  m  turn  present  them  to  this 
bank  for  credit  to  their  accounts,  it  is  obvious  that,  while  there 
will  be  an  ever-changing  personnel  of  depositors,  the  total  of 
deposits  will  remain  at  $98,000. 

Now  in  practice  not  every  business  man  would  desire  to 
bank  with  this  particular  institution,  and  not  everyone  who  did 
keep  his  account  there  would  always  refrain  from  withdrawing 
any  cash.  Suppose,  for  instance,  one  of  these  checks  comes 
into  the  hands  of  Z  and  that  Z  is  a  depositor  in  another  bank 
in  the  same  city.  Z  will  take  the  check  to  the  other  bank  and 
there  deposit  it  to  his  credit.  But  if  bank  No.  2  gives  Mr.  Z 
a  deposit  account  of,  say,  $10,000  upon  the  presentation  of  a 
check  on  bank  No.  i  for  that  amount,  it  is  obvious  that  bank 
No.  2  must  collect  that  amount  from  bank  No.  i.     While 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      369 

we  shall  later  see  that  as  a  rule  this  does  not  ordinarily  involve 
the  parting  with  much  cash  by  bank  No.  1/  for  the  present 
it  is  important  merely  to  note  that,  even  though  some  of  the 
checks  drawn  against  the  deposit  accounts  in  bank  No.  i  are 
presented  to  other  banks,  the  total  deposit  accounts  resulting 
from  the  original  loan  remain  unchanged.  Unchanged,  except 
of  course  insofar  as  cash  may  be  actually  withdrawn  from  some 
bank  by  some  individual  into  whose  hands  a  check  has  come. 
If,  for  example,  Mr.  Y  elects  to  cash  a  check  for  $10,000  that  has 
been  drawn  against  bank  No.  i,  he  would  of  course  not  receive  a 
deposit  account;  but  on  the  assets  side  cash  would  be  reduced  by 
$10,000.' 

Commercial  banks  also  receive  deposits  of  cash  and  of  claims 
to  cash.  Let  us  now  carry  through  some  additional  operations 
with  this  newly  organized  national  bank.  It  has  already  been 
stated  that  in  practice  commercial  bank  deposits  also  arise  as  a 
result  of  the  bringing  of  cash  to  the  bank  by  individuals.  Let 
us  assume  that  a  customer  desires  to  open  a  checking  account 
with  the  bank.  He  presents  through  the  paying  teller's  window 
the  following  things:  (i)  $1,000  in  cash;  (2)  $1,000  in  checks 
on  other  banks  which  are  members  of  the  Clearing  House 
Association;  (3)  $2,000  in  checks  on  other  banks  in  this  town, 
not  members  of  the  Clearing  House  Association;  (4)  $2,000 
in  checks  on  banks  in  other  cities;  (5)  $3,000  in  certified  checks 
on  this  bank;  (6)  $3,000  in  cashier's  checks  on  this  bank: 
(7)  $4,000  in  drafts  on  correspondent  banks;  and  (8)  $4,000  in 
notes  of  other  national  banks.  The  depositor  will  have  entered 
to  his  credit  as  a  deposit  the  sum  of  these  items,  or  $20,000. 
On  the  assets  side,  the  cash  would  be  increased  by  $1,000 
and  the  remaining  items  would  find  reflection  on  the  balance 
sheet  under  the  headings:  exchanges  for  the  clearing  house; 
checks  on  other  banks  in  this  city;  checks  on  out-of-town  banks; 
due  from  banks  and  bankers;    and  notes  of  other  national 

*See  pp.  476-77. 

*A  more  complete  explanation  of  the  process  of  creating  deposits  here 
suggested  and  the  general  significance  of  this  phenomenon  must  be  reserved 
for  subsequent  discussion  (see  pp.  475-83). 


370         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

banks.  On  the  liabilities  side,  the  cashier's  checks  outstanding 
would  be  decreased  by  $3,000,  and  the  certified  checks  by  a 
like  amount. 

Investments  in  securities  are  analogotis  to  loans.  Let  us 
suppose  the  bank  makes  investments  of  $50,000  in  Liberty 
bonds  and  $20,000  in  other  bonds.  These  items  on  the  assets 
side  of  the  balance  sheet  would  of  course  be  increased  by  the 
amounts  specified;  and  the  individual,  government,  or  cor- 
poration from  whom  these  bonds  were  purchased  could  either 
ask  for  payment  in  actual  specie  or  take  a  deposit  account  with 
the  bank,  against  which  checks  might  be  written  at  will.  The 
process  here  is  identical  with  that  discussed  above  in  the  case 
of  loans. 

Issuing  notes  is  an  important  feature  of  national  bank  opera- 
tions. Another  type  of  banking  operation  is  that  of  note 
issue — an  operation  which  at "  the  present  time  is  confined 
to  the  national  banks.  The  process  of  issuing  notes  may  best 
be  stated  as  an  analogy  to  the  process  of  creating  deposits 
through  the  making  of  loans.  An  individual  who  secures  a 
loan  from  the  bank  may  be  paid  by  an  issue  of  bank  notes  as 
well  as  by  the  taking  of  a  deposit  account.  Under  our  banking 
laws,  however,  an  issue  of  notes  must  have  a  special  form  of 
security.  If  a  bank  wishes  to  make  an  issue  of  $1,000  worth  of 
bank  notes,  it  must  first  deposit  with  the  United  States  Treasury 
$1,000  worth  of  bonds.'  The  Treasury  then  prepares  the  notes 
and  sends  them  to  the  bank,  where  they  must  be  signed  by  the 
proper  officials  before  being  issued.  Thus,  every  note  out- 
standing is  backed  dollar  for  dollar  by  government  bonds 
in  the  vaults  of  the  United  States  Treasury  as  trustee,  and  in 
addition  by  the  resources  of  the  bank,  against  which  the  notes 
have  a  prior  lien.  It  is  also  required  that  the  bank  deposit  in 
the  Treasury  at  Washington  a  cash  reserve  fund  of  5  per  cent, 
to  be  used  in  the  redemption  of  any  notes  that  may  be  pre- 

*The  law  holds  that  if  the  bonds  are  worth  more  than  par,  notes  can 
nevertheless  be  issued  only  to  the  par  value  of  the  bonds,  and  that,  if  the 
bonds  are  worth  less  than  par,  the  amount  of  notes  must  not  be  in  excess 
of  the  market  value  of  the  bonds. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      371 

sented  there  for  payment,  the  law  making  them  redeemable 
at  par  by  the  United  States  government. 

National  bank  notes  do  not  possess  full  legal  tender  power. 
Such  notes  are  a  direct  liability  of  the  bank  which  issues  them 
and  they  are  redeemable  in  cash  upon  demand  at  the  bank  of 
issue  as  well  as  at  the  federal  Treasury.  Every  bank  in  the 
national  system  must  also  accept  at  par  the  notes  of  every 
other  national  bank;  and  such  notes  are  also  receivable  at  par 
in  payments  to  the  United  States  government,  except  for 
duties  on  imports.  The  government,  moreover,  may  use  them 
in  paying  all  of  its  obligations,  except  interest  on  the  public  debt 
and  in  the  redemption  of  other  national  bank  notes.  National 
bank  notes,  however,  have  never  been  made  legal  tender  in  the 
settlement  of  private  accounts. 

The  issue  of  notes  has  been  declining  in  importance  during 
the  last  fifty  years.  The  issue  of  bank  notes  was  once  the  chief 
method  of  making  loans  by  commercial  banks;  and  in  the 
nations  of  continental  Europe  it  is  still  the  most  important 
means  of  extending  credit.  But  in  England  and  the  United 
States  bank  note  issues  have  in  the  last  hundred  years  steadily 
declined  in  importance.  The  table  on  page  372  reveals  the 
changes  in  the  relative  proportion  of  notes  and  deposits  in  dif- 
ferent classes  of  national  banks  in  the  last  fifty  years.  It  will 
be  seen  that  the  relative  importance  of  note  issue  has  been 
growing  less  in  all  classes  of  banks;  and  that  its  significance 
varies  inversely  with  the  size  of  the  financial  center  in  which 
the  issuing  bank  is  located.  A  word  of  explanation  of  this 
classification  of  national  banks  is  necessary.  The  national 
banking  law  divides  the  national  banks  of  the  country  into 
three  classes:  first,  those  in  central  reserve  cities,  namely. 
New  York,  Chicago,  and  St.  Louis;  second,  those  in  reserve 
cities,  which  constitute  about  sixty  of  the  remaining  larger 
cities  of  the  country;  and  third,  country  banks,  which  include 
all  those  not  located  in  central  reserve  and  reserve  cities. 

Of  the  remaining  items  on  the  balance  sheet  on  pages  364-65 
a  few  words  of  explanation  will  suffice.  "Customer's  liability 
on  account  of  drafts  paid  under  letters  of  credit  for  which  this 


372 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


bank  has  not  been  reimbursed"  represents  money  paid  out  for 
the  purpose  indicated  and  is  in  the  nature  of  a  loan  to  a  cus- 
tomer.' This  item  should  be  compared  with  "Letters  of  credit 
and  travelers'  checks  sold  for  cash  and  outstanding"  on  the  lia- 
bilities side.  It  will  be  seen  that  except  for  the  $3 ,6 23 .  38  carried 
under  "Customers'  liability  on  accoimt  of  drafts,  etc.,"  the 
bank  has  already  received  funds  for  the  remainder  of  the 

DECLINING  IMPORTANCE  OF  NOTE  ISSUES 
(In  millions  of  dollars)  * 


Year 

New  York  City 

Other  Central 

Reserve  and 
Reserve  Cities 

Country  Banks 

Totals 

Notes 

Deposits 

Notes 

Deposits 

Notes 

Deposits 

Notes 

Deposits 

1870 

1875 

1880 

i88s 

1890 

189s 

1900 

1905 

1909 

i9iot 

191st 

I9i9t 

329 
18.3 
18.6 
9-9 
3-6 
14-3 
29-3 
53-7 
52-8 
49.0 
37-3 
37-7 

167.0 

173-5 
242.0 

250.5 
251-4 
299.7 
420.7 

657-7 
780.0 
962.5 
849.1 
1,912.9 

68.4 

69-4 

72-4 

55-3 

I5-I 

32-7 

637 

120.4 

181. 8 

191 .6 

204.1 

183.9 

134-7 

197.9 

234-3 

302,1 

469.6 

509-3 

775-2 

1,086.5 

1,477-2 

2,134-7 

1,621.0 

4,603.4 

190.5 
230.7 
226.4 
203.7 
104.2 

135-4 
190.9 

294-9 
423-5 
449-3 
477-1 
460.0 

199 
293 
397 
549 
843 
892 
1,312 
2,076 

2,754 
3,108 
2,171 
4,235 

7 
2 
2 
8 
8 
7 
3 
5 
9 
8 

4 
2 

291.8 
318.4 
317-4 
268.9 
122.9 
182.5 
283.9 
459-0 
658.1 
680.4 
718. 5 
681.6 

SOI.  4 
664.6 

873-5 
1,102.4 
1,564.8 
1,701.7 
2,508.2 
3,820.7 
5,012.1 
6,206  0 
4,641 -5 
9,751  5 

♦From  Slattslics  of  Banks  and  Banking  in  (he  United  Stales,  1867-1909. 
tary  Commission,  1910.) 

t  From  annual  reports  of  the  Comptroller  of  Currency. 


(National  Mone 


$209,458 .71.  "  Customers'  liability  on  account  of  acceptances  " 
will  be  clear  after  reading  the  discussion  of  bank  acceptances 
below.*  This  item  should  be  compared  with  "Acceptances" 
on  the  liabilities  side. 

"United  States  government  securities  deposited  ....  to 
secure  note  circulation"  has  already  been  explained.  It  should 
be  compared  with  the  item  "circulating  notes  outstanding"  op 
the  liabilities  side  of  the  balance  sheet.    "  United  States  govern 

•For  a  discussion  of  letters  of  credit  see  pp.  411-17. 
■See  pp.  601-3. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      373 

ment  securities  pledged  to  secure  United  States  deposits" 
indicates  that  this  bank  holds  some  of  the  funds  of  the  United 
States  Treasury  and  has  put  up  government  bonds  as  security. 
The  Secretary  of  the  Treasury  is  authorized  by  law  to  denote 
certain  national  banks  as  depositaries  of  government  funds — 
the  purpose  being  to  minimize  at  all  times  the  volume  of  fimds 
that  is  withdrawn  from  circulation  in  connection  with  the 
fiscal  operations  of  the  Treasury.^  "United  States  govern- 
ment securities  pledged  to  secure  state  or  other  deposits"  is  of 
similar  nature  and  purpose.  "United  States  government 
securities  pledged  to  secure  bills  payable"  indicates  that  this 
bank  has  borrowed  from  the  Federal  Reserve  bank  on  its  own 
promissory  notes  and  has  deposited  government  bonds  as 
collateral.'  This  item  should  be  compared  with  "  Bills  payable 
with  Federal  Reserve  banks"  on  the  liabilities  side.  "United 
States  certificates  of  indebtedness"  refers  to  the  short-term 
notes  issued  by  the  Treasury  Department  as  a  means  of  raising 
revenue  to  meet  current  expenses  pending  the  receipt  of  regular 
income. 

"Items  with  Federal  Reserve  bank  in  process  of  collection" 
refers  to  checks  which  this  bank  has  received  from  its  depositors 
which  the  Federal  Reserve  Bank  of  Chicago  is  collecting  from 
the  banks  upon  which  they  are  drawn.^  The  "Lawful  reserve 
with  the  Federal  Reserve  bank"  is  the  amount  of  funds  which 
the  law  requires  this  bank  to  keep  on  deposit  with  the  Federal 
Reserve  Bank  of  Chicago.* 

"Due  from  national  banks"  and  "Due  from  state  and 
private  banks"  indicate  that  this  bank  has  funds  on  deposit 
with  other  national  and  state  banks.  This  item  should  be 
compared  with  "Due  to  national  banks"  and  "Due  to  state 
and  private  banks"  on  the  liabilities  side.  It  will  be  noted 
that  the  total  "Due  to  banks  "in  the  Continental  and  Commercial 
National  Bank  statement  is  much  greater  than  the  amount 
"Due  from  Banks";  while  with  the  Maywood  bank  the  reverse 

*  See  pp.  502-5. 

'Seep.  592.  »See  pp.  610-11. 

<See  reserve  requirements  under  Federal  Reserve  System,  pp.  590-91. 


374         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

is  true.  The  banks  in  the  central  reserve  and  reserve  cities 
characteristically  hold  large  volumes  of  funds  for  outlying 
banks;  and  it  is  necessary  for  them  to  have  some  of  their  own 
funds  deposited  in  other  centers,  also,  to  facilitate  financial 
operations  in  such  centers.* 

"Redemption  fund  with  United  States  Treasury"  is  5  per 
cent  of  the  "national  bank  notes  outstanding,"  in  accordance 
with  the  legal  requirements,  as  already  outlined. 

On  the  liabilities  side,  the  item  "Reserved  for  taxes  accrued" 
indicates  that  preparation  is  being  made  for  meeting  the  tax  bill 
payments  by  creating  a  reserve  for  the  purpose.  When  the 
payment  is  made,  this  item  will  disappear  and  there  will  be  a 
corresponding  reduction  in  cash  on  the  assets  side.  Deposits 
are  divided  into:  "Individual  deposits  subject  to  check"; 
"Certificates  of  deposit  due  in  less  than  thirty  days;"  "Time 
Certificates  of  deposit";  and  "United  States  deposits."  The 
"Individual  deposits  subject  to  check"  are  the  ordinary  check- 
ing accoxmts  of  individuals  and  businesses.  The  "  Certificates 
of  deposit"  represent  funds  which  cannot  be  checked  against, 
but  can  be  withdrawn  only  by  presentation  of  certificates,  which 
are  receipts  for  the  money  deposited.  "Time  certificates  of 
deposit"  are  listed  separately  because  of  a  separate  reserve 
requirement.'  "United  States  deposits"  are  deposits  of  the 
United  States  government  against  which  no  reserve  need  be 
carried. 

IV.    ANALYSIS  OF  COMMERCIAL  BANK  LOANS 

Since  a  commercial  bank's  profits  are  mainly  derived  from 
loans  and  investments,  the  test  of  efficient  bank  management 
is  to  be  found  in  the  wisdom  with  which  such  extensions  of 
credit  are  made.  The  making  of  loans  and  investments  by 
commercial  banks  is  a  matter  of  exceptional  importance,  more- 
over, by  virtue  of  the  fact  that  these  institutions  are  by  their 
very  nature  committed  to  paying  depositors  upon  demand. 
If  a  bank  has  insufficient  funds  on  hand  with  which  to  meet 

■*  See  discussion  on  pp.  470-75.  *Seep.  591. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      375 

demands  for  cash  and  if  it  is  unable  to  secure  them  from  any 
source,  it  must  close  its  doors  and  announce  insolvency,  not- 
withstanding the  fact  that  ultimately  its  assets  may  prove 
ample  to  meet  the  claims  of  depositors  in  full.  Since  the 
entire  modern  business  structure  is  dependent  upon  the  smooth 
functioning  of  financial  institutions,  commercial  banks  are  in  a 
position  of  exceptional  responsibility.  They  are  the  final 
repositories  of  the  cash  resources  of  the  nation;  and  upon  the 
efficiency  of  their  operation  depends  the  safety,  as  well  as  the 
adaptability  to  the  needs  of  business,  of  the  whole  complex 
credit  structure.  Bank  failures  and  bank  suspensions  of 
specie  payments,  due  to  inadequate  cash  reserves,  always  bring 
in  their  train  more  or  less  disaster  to  business  in  general. 
Accordingly  the  development  of  a  "loan  policy"  is  the  most 
vital  problem  of  bank  management. 

In  the  making  of  bank  loans  there  are  two  main  problems. 
First,  there  must  be  assurance  that  the  borrowers  are  all  in 
sound  financial  position — that  the  loans  will  surely  be  safe. 
Second,  the  maturities  of  loans  must  be  arranged  so  as  to 
facilitate  meeting  the  varying  demands  for  cash  at  different 
times  and  at  different  seasons.  We  shall  presently  see  that 
the  problem  of  maintaining  adequate  cash  resources  with 
which  to  meet  these  varying  needs  largely  depends,  in  a  highly 
developed  banking  structure,  upon  inter-bank  relations,  upon 
the  organization  of  the  banking  system  as  a  whole.  But  since 
the  individual  bank  is  the  unit  of  the  system,  we  may  best 
begin  our  study  by  a  consideration  of  the  various  types  of 
lending  operations  that  are  engaged  in  by  the  typical  commercial 
banking  institutions. 

There  are  several  types  of  hank  loans.  The  ordinary  com- 
mercial bank  has  the  option  of  loaning  funds  (extending  credit) 
in  the  following  ways:  (i)  on  single-name  promissory  notes  of 
individuals  and  corporations;  (2)  on  two-name  paper — indorsed 
notes  and  accepted  drafts  (trade  acceptances);  (3)  on  the 
security  of  real  estate  mortgages;  (4)  on  promissory  notes 
secured  by  other  notes  as  collateral;  (5)  on  promissory  notes 
secured  by  stocks  and  bonds;  (6)  on  drafts  secured  by  bills  of 


376         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

lading;  (7)  on  promissory  notes  and  drafts  secured  by  ware- 
house receipts;  (8)  by  investments  in  stocks,  bonds,  short- 
term  notes,  mortgages,  etc. 

Loans  may  also  be  classified  according  to  whether  they  are 
time  loans  (thirty,  sixty,  ninety  days  or  more)  or  demand  loans. 
Demand  loans  are  of  two  types:  (i)  the  so-called  "call"  loans, 
where  the  loan  is  of  indefinite  duration  but  terminable  at  a 
moment's  notice  at  the  option  of  either  the  bank  or  borrower; 
these  are  found  only  in  New  York  City,  and  are  used  in  con- 
nection with  stock  market  speculation;'  (2)  demand  loans, 
where  it  is  understood  that  the  bank  will  allow  the  loan  to  run 
indefinitely,  in  the  absence  of  any  untoward  development 
which  might  imperil  its  ultimate  safety.  Such  a  loan  is  in 
effect  ordinarily  terminable  only  at  the  option  of  the  borrower. 

The  table  on  page  377  shows  the  dififerent  classes  of  loans 
made  by  the  national  banks  on  June  30,  1919: 

Another  classification  of  bank  loans — one  which  rims  in 
terms  of  the  use  to  which  the  funds  borrowed  are  to  be  devoted 
— ^is  that  of  commercial  and  investment  loans.  Commercial 
and  investment  loans  present  no  new  phenomenon  to  the 
reader;  for  they  have  already  been  discussed  in  chapter  ix 
under  commercial  and  investment  credit.  It  may  merely  be 
recalled  here  that  commercial  loans  are  used  for  working 
capital  purposes.  Whether  with  producer  of  raw  materials, 
manufacturer,  commission  merchant,  wholesaler,  or  retailer, 
the  fimds  borrowed  are  employed  in  meeting  pay-roll  require- 
ments or  in  buying  the  materials  or  goods  required  in  the 
operation  of  the  business.  They  usually  run  for  short  periods 
by  virtue  of  the  fact  that  the  time  required  to  carry  to  fruition 
the  productive  process  in  which  they  are  assisting  is  ordinarily 
of  relatively  short  duration.' 

With  investment  loans,  on  the  other  hand,  the  funds  are 
devoted  to  fixed  capital  purposes;  hence  such  loans  are  usually 
of  relatively  long  duration.    In  the  course  of  our  analysis  we 

*  See  discussion  below,  pp.  391-93. 

»We  shall  later  see,  however,  that  commercial  loans  are  not  so 
commonly  paid  at  maturity  as  is  generally  assumed.    See  pp.  532-33. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAT.  BANK      377 

shall  have  occasion  to  show  that  the  commercial  banks  furnish 
funds  for  fixed  capital  purposes  in  various  ways — some  of 
them  direct,  others  indirect.  We  shall  also  have  occasion, 
in  a  succeeding  chapter,  to  consider  the  relative  liquidity  of  the 


CLASSIFICATION  OF  NATIONAL  BANK  LOANS' 
(In  thousands  of  dollars) 


New  York 


Chicago 


St. 
Louis 


Total 
Central 
Reserve 

Cities 


Other 
Reserve 
cities 


Country 
Banks 


Total 
United 
States 


On  demand,  paper  with  one 
or  more  individual  or 
firm  names  (not  secured 
by  collateral) 

On  demand,  secured  by 
stocks  and  bonds 

On  demand,  secured  by 
other  personal  securities, 
including  merchandise, 
warehouse  receipts,  etc.  . 

On  time,  paper  with  one  or 
more  individual  or  firm 
names  (not  secured  by 
collateral) 

On  time,  secured  by  stocks 
and  bonds 

On  time,  secured  by  other 
personal  securities,  in- 
cluding merchandise, 
warehouse  receipts,  etc.  . 

Secured  by  real  estate  mort- 
gages or  other  liens  on 
realty  not  in  accordance 
with  section  24,  Federal 
Reserve  Act  as  amended . 

Secured  by  improved  real 
estate  under  authority  of 
section  24,  Federal  Re 
serve  Act  as  amended  . . . 

Acceptances  of  other  banks 
discounted 

Acceptances  of  this  bank 
purchased  or  discoimted 


36,166 
454.928 


QS4.023 
679,867 

109,605 
72s 


34,611 
78,373 

3»,637 

250,241 
Ss.Qlo 

47.643 
734 


78,830 
22,119 


559 
2,387 


7.989 
29,602 

6,471 

67,587 
23.829 


374 

1,009 

6,871 

737 


78,766 
562,903 

127,563 

1,271,851 
789,606 

167,743 

1,833 

1,009 
86,260 

25,243 


182,702 
439,337 


1,532,805 
744,110 

312,747 

19,17s 

7,304 
58,701 
21.567 


336,092 
305,547 

87.130 

2,446,668 
596,882 

533.583 

69,650 

85,011 
5,888 
9.937 


597.560 
1,307,787 

317,286 

5,251,324 
2,130,598 


90,658 

93,324 

150,849 

56,747 


Total 2,424,718  533,095 


154.964 


3,112,777 


4.476,388 


11,010,206 


various  types  of  investment  and  commercial  loans.  For  the 
present,  however,  we  are  merely  concerned  with  describing 
the  different  types  of  commercial  bank  loans  and  showing 
the  uses  to  which  the  funds  thus  borrowed  are  devoted. 

I.  Single-name  borrowing.    Borrowing  on  the  single-name 
promissory  notes  of  individuals  or  corporations  has  come  to  be 

*From  Report  of  the  Comptroller  of  the  Currency,  I  (191 9),  50 


378         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

one  of  the  most  common  means  of  obtaining  loans  in  the  United 
States.  The  reason  for  this  has  already  been  suggested  in 
the  chapter  on  commercial  credit  instruments.'  Such  borrowing 
may  or  may  not  be  for  working  capital  purposes,  though  in 
practice  it  is  in  the  great  majority  of  cases  of  a  general  com- 
mercial nature.  It  is  often  assumed  that  a  loan  made  on  a 
single-name  promissory  note,  unsecured  by  collateral,  must 
in  the  nature  of  things  be  less  satisfactory  from  the  standpoint 
of  safety  than  two-name  or  collateral  paper.  We  shall  find, 
however,  that  this  is  by  no  means  the  case.  In  fact,  single- 
name  paper  is  on  the  whole  just  as  safe  as  any  other. 

As  between  single-name  paper  and  indorsed  notes,  it  may  be 
observed  that  loans  for  business  purposes  are  seldom  obtained 
by  business  man  A  on  the  accommodation  indorsement  of 
bjisiness  man  B.  The  most  common  form  of  two-name  paper 
in  the  United  States  has  until  recently  been  that  which  arises 
out  of  the  discounting  of  customers'  notes.'  Mr.  A.  sells  goods 
to  Mr.  B,  and  requires  B  to  give  a  promissory  note  as  evidence 
of  the  transaction.  Now  A  may  discount  this  note  with  the 
bank,  indorsing  it  in  the  process.  Many  people  feel  that  in 
numbers  there  is  strength  and  that  since  the  bank  here  has  two 
persons  to  whom  it  may  look  for  payment,  the  note  is  doubly 
secure.  The  truth  of  the  matter  is,  however,  that  as  a  rule 
the  bank  looks  for  payment  only  to  the  party  who  presented 
the  note  to  the  bank,  namely,  to  the  indorser — the  reason  for 
this  being  that  the  ordinary  drawer  of  the  note  is  generally 
unknown  to  the  bank,  whereas  the  indorser  is  usually  a  regular 
customer.  The  safety  of  the  bank  loan,  therefore,  primarily 
depends  upon  the  standing  of  the  individual  upon  whom  the 
bank  relies  for  payment.  And  whether  a  note  be  two-name 
or  single-name,  the  bank  makes  the  loan  on  the  basis  of  its 
knowledge  of  the  integrity  and  ability  of  the  borrower — that  is, 
of  the  indorser  in  the  case  of  a  discounted  customer's  note. 

Lending  on  single-name  paper  requires  a  careful  analysis  of 
the  borrower's  financial  integrity  and  ability.    Since  the  safety 

'  See  p.  169. 

*  For  a  discussion  of  the  trade  acceptance  see  pp.  384-85. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      379 

of  loans  depends  upon  the  accuracy  of  the  bank's  knowledge 
of  the  borrower,  it  is  incumbent  upon  the  bank  to  make  a 
careful  investigation  of  his  integrity,  ability,  and  financial 
resources.  As  a  preliminary  to  a  consideration  of  the  making 
of  bank  loans,  it  will  be  of  service  to  recall  the  outline  of  the 
factors  involved  in  credit  extension  given  on  page  126  above. 

In  its  analysis  of  the  character  and  integrity  of  the  borrower 
— of  his  intention  and  willingness  to  pay — the  credit  department 
of  a  bank  has  recourse  to  various  sources  of  information.  It 
sends  out  letters  to  references  given  by  the  credit  applicant  and 
to  others  whose  opinions  might  be  of  value;  and  it  secures 
reports  from  the  commercial  agencies,  and  from  other  banks 
with  whom  this  borrower  has  had  relations.  A  personal 
interview  is  usually  requested  in  order  that  a  first-hand  impres- 
sion may  be  gained;  and  considerable  collateral  information 
is  often  "picked  up"  from  trade  reports,  newspaper  comments, 
etc.,  as  well  as  from  the  general  "gossip"  of  the  business 
community. 

The  commercial  agencies,  of  which  the  chief  are  Dun's 
and  Bradstreet's,  assemble  data  on  the  history  and  present 
status  of  the  various  businesses  of  the  country  and  give  to 
each  a  general  credit  "rating" — good,  bad,  or  indifferent. 
These  mercantile  reports  aim  to  cover  the  entire  field  of  business 
and  include  every  corporate  and  individual  enterprise;  but 
with  new  concerns  springing  up  daily,  it  is  of  course  impossible 
in  practice  to  furnish  recent  information  on  all  establishments. 
A  serious  handicap  to  reliable  information  lies  in  the  fact  that 
the  agency  reporters  are  not  always  treated  with  the  greatest 
freedom  and  confidence;  in  some  instances,  indeed,  there  is  an 
evident  desire  on  the  part  of  businesses  to  strengthen  their 
rating  by  deliberate  deception.  Moreover,  the  reporters  are 
relatively  poorly  paid  and  hence  many  of  them  are  not  par- 
ticularly well  qualified  for  the  work  in  hand.  Nevertheless,  the 
service  rendered  is  invaluable  in  the  case  of  many  small  enter- 
prises, and  it  is  an  important  source  of  collateral  information 
in  nearly  all  instances.  It  may  be  added  that  upon  request  the 
agencies  furnish  special  up-to-date  reports  to  their  customers. 


380         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

In  the  large  financial  centers  analysis  of  the  borrower's  finan- 
cial statement  is  now  regarded  as  indispensable  to  an  intelligent 
extension  of  credit.  By  far  the  most  important  source  of  credit 
information,  nowadays,  is  the  financial  statement,  with  supple- 
mentary information  that  is  furnished  directly  by  the  borrower. 
The  use  of  the  financial  statement  as  a  basis  for  loans  dates 
back  only  to  the  nineties,  and  its  great  development  has  been 
mainly  a  matter  of  the  last  fifteen  years.  Even  now  the  use  of 
the  statement  is  chiefly  confined  to  the  larger  cities;  though  it 
is  steadily  gaining  in  vogue  in  the  smaller  cities  and  towns. 
Before  the  advent  of  the  financial  statement  the  banker  relied 
only  upon  his  general  knowledge  of  the  borrower's  honesty 
and  business  ability.  And  so  long  as  industry  was  conducted 
on  a  relatively  small  scale  and  business  relations  were  of  a 
highly  personal  sort,  by  direct  observation  and  by  the  current 
gossip  of  the  community  with  which  he  was  in  intimate  touch 
the  banker  could  obtain  a  fairly  accurate  line  on  credit  risks. 
But  with  the  great  growth  in  the  size  of  business  undertakings 
in  the  last  generation,  together  with  the  inherent  impersonality 
of  urban  life,  the  bankers  of  the  financial  centers  have  found  it 
imperatively  necessary  to  supplement  personal  impression  and 
gossip  by  investigation  based  upon  the  financial  records  of 
the  borrowing  corporation  or  business.  The  development  of 
systematic  accounting  methods  necessitated  by  the  great  size 
and  complexity  of  business  was  of  course  an  indispensable 
hand-maiden  to  the  change  in  the  methods  of  credit  extension; 
for  without  accounting  records  it  would  be  quite  impossible  to 
make  an  investigation  of  the  condition  of  a  large-scale  enterprise 
that  would  have  any  meaning. 

Different  banks  use  somewhat  different  forms  of  financial 
statements.  A  typical  form  for  corporations*  is  shown  on  page 
381.  It  will  be  observed  that  it  contains  an  income  or  profit  and 
loss  account,  as  well  as  a  statement  of  resources  and  liabilities. 

Besides  the  balance  sheet  and  profit  and  loss  account, 
collateral  information  is  requested  as  follows:  (1)  contingent 
liabilities;    (2)  fire  insurance  on  merchandise,  on  buildings, 

'  There  is  a  separate  form  for  individuals  and  partnerships. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      381 

and  on  the  machinery  and  tools;   (3)  life  insurance  on  officers' 
lives;   (4)  average  amount  of  goods  on  hand;   (5)  at  what  time 


l^»IS  B*n 


BORROWER'S   STATEMENT Corporation. 


Nune  (Corporate  ttyU  nnclcr  cKarter)^ 


To  the  UNION  TRUST  COMPANY. 

Tke  foDowing  it  *  true  atatem«nt  of  ihe  luuncUl  conditia 


of  thi*  corporatioa  on  lhe_ 


-if 


•ude  to  lie  UNION  TRUST  COMPANY,  (or  llwpwpoMololiaiDiacciwIil.    W«  aftM  Is 


aotifr  Mid  B*tik  procnptly  ol  aajr  naterul  -'-inpi  ia  mu  conditi< 

FILL  ALL  UL.\NKS  ttRlriNG  'NO'  Oft  -NONE"  WHERE  NECESSARY. 


ASSETS 

UABILmES 

CJ,  on  h.nd 



— 

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Note*  Parable  to  oilier  banka  or  (or  papw  aold 

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•oH » 

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— 

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Accounu  over  60  ijayt  put  due 

Bonded  Debt.            _         (when  due          .        ) 



— 



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r^P^f-i 

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TOTAL 

TOTAL 

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tOlM, 

XOIAL 

of  the  year  liabilities  are  heaviest  and  at  what  time  lightest; 
(6)  total  sales  for  last  fiscal  year;  (7)  average  terms  of  sales 
and  average  terms  of  purchases;    (8)  regular  time  of  taking 


382         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

inventory;  (9)  suits  pending  against  the  corporation; 
(10)  authorized  capital,  subscribed  and  paid  in;  (11)  annual 
dividends.  The  names  and  addresses  of  the  officers  and 
directors  are  also  called  for  with  a  statement  of  the  number  of 
shares  of  stock  held  by  each.  There  are  also  blanks  for  trade 
and  for  bank  references. 

There  is  no  occasion  here  for  making  a  detailed  analysis  of  a 
financial  statement.  Suffice  it  to  say  that  from  the  standpoint 
of  bank  management  the  most  significant  items  on  the  balance 
sheet  are  the  liquid  assets  and  liabilities,  or,  as  the  phrase 
usually  goes,  the  quick  assets  and  current  liabilities.  The 
quick  assets  are:  cash  on  hand  and  in  banks;  notes  and  accoimts 
receivable;  merchandise;  and.  raw  materials.  The  current 
liabilities  are:  notes  and  accounts  payable;  and  any  other 
debts  that  are  payable  within  a  few  months.  All  of  the  items 
on  the  Uabilities  side  except  capital  and  surplus  may  usually  be 
regarded  as  current. 

Suppose  now  that  a  borrower  who  desires  a  loan  of  $100,000 
presents  a  financial  statement  to  the  bank  which  shows  quick 
assets  totaling  $800,000  and  current  liabihties  amounting  to 
only  $200,000,  Can  the  loan  safely  be  granted,  assuming 
that  the  management  of  the  concern  is  in  honest  and  capable 
hands  ?  The  banker  sees  that  within  the  next  few  months  the 
company  will  have  to  meet  $200,000  of  obligations,  besides  the 
$100,000  which  would  be  owing  to  the  bank  in  ccae  the  loan 
were  made.  By  reference  to  the  quick  assets  he  discovers  that 
the  company  either  has  on  hand  as  cash,  or  will  have  as  cash 
income  during  the  same  period,  $800,000,  to  which  may  be  added 
the  $100,000  borrowed  from  the  bank,  which  we  may  assume  is 
to  be  used  in  buying  additional  raw  materials.  This  is  $600,000 
more  than  the  current  liabilities.  The  company  could  thus 
suffer  substantial  losses  through  the  failure  of  its  debtors  to  pay 
notes  and  accounts  in  full  and  through  depreciation  of  merchan- 
dise and  raw  materials  before  its  ability  to  meet  all  current 
liabilities  would  be  imperiled.  Indeed,  the  quick  assets  would 
have  to  diminish  more  than  two-thirds  before  the  business 
would  be  unable  to  meet  its  current  obligations  in  full. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      383 

The  excess  of  quick  assets  over  current  liabilities  consti- 
tutes the  margin  of  safety  for  the  banker.  There  is  a  general 
credit  rule  to  the  effect  that  the  quick  assets  should  be  at  least 
double  the  current  liabilities.  The  margin  required  for  safety, 
however,  varies  widely  in  different  lines  of  business,  at  different 
times,  and  even  in  different  locaHties.  One  must  accordingly 
regard  this  rule  as  only  a  very  rough  approximation. 

Fixed  assets  and  long-time  liabilities,  the  profit  and  loss 
account,  and  the  information  contained  in  the  answers  to  the 
appended  questions  are  used  as  collateral  information  and  as 
checks  on  the  accuracy  of  the  financial  statement.  Concretely, 
if  the  ratio  of  quick  assets  to  current  habilities  were  in  a  given 
case  a  scant  two  to  one,  and  if  the  account  in  general  looked 
very  doubtful,  the  information  presented  in  the  statement  of 
fixed  assets  and  liabilities,  in  the  profit  and  loss  account,  and 
in  the  answers  to  the  appended  questions  might  nevertheless 
indicate  that  the  loan  could  safely  be  granted.  On  the  other 
hand,  an  apparently  satisfactory  statement,  so  far  as  quick 
assets  and  current  liabilities  are  concerned,  sometimes  appears 
very  different  in  the  light  of  these  collateral  data. 

Funds  borrowed  on  single-name  paper  are  sometimes  devoted 
to  fixed  capital  purposes.  It  has  already  been  stated  that  the 
funds  borrowed  on  single-name  promissory  notes  are  usually, 
though  not  always,  devoted  to  working  capital  purposes. 
In  the  illustration  above  we  assumed  that  the  loan  of  $100,000 
was  used  for  the  purchase  of  additional  raw  material,  thereby 
increasing  the  quick  assets  by  $100,000.  If  the  funds  were 
used,  however,  to  build  additional  warehouses,  or  to  buy 
additional  equipment,  there  would  be  an  increase  in  the  fixed 
and  not  in  the  quick  assets.  In  this  case  the  ratio  of  quick 
assets  to  current  liabilities,  after  the  loan  had  been  made,  would 
be  $800,000  to  $300,000  rather  than  $900,000  to  $300,000.  The 
use  of  these  funds  for  fixed  capital  purposes  would  not,  however, 
necessarily  make  the  loan  unsafe  or  much  less  likely  to  be  paid 
at  maturity;  the  inflow  of  funds  to  the  business  within  the  life 
of  the  loan  might  still  be  more  than  sufficient  to  permit  the  pay- 
ment of  the  loan  at  maturity. 


384         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

While  funds  borrowed  from  the  commercial  banks  are  thus 
frequently  employed  for  fixed  capital  purposes,  it  nevertheless 
remains  true  that  most  of  the  credit  extended  in  this  form  by 
commercial  banks  is  devoted  to  the  purchase  of  raw  materials 
or  stocks  of  goods  to  be  used  in  the  operation  of  the  factory, 
store,  or  other  business  establishment. 

2.  Two-name  borrowing.  One  type  of  two-name  borrowing, 
that  on  indorsed  customers'  notes,  has  already  been  discussed. 
There  remains  for  consideration  only  the  trade  acceptance.  It 
has  often  been  said  that  the  trade  acceptance  is  of  particular 
advantage  in  that  it  enables  the  business  man  to  obtain  much 
more  working  capital  than  would  otherwise  be  the  case.  The 
trade  acceptance,  it  is  said,  represents  an  actually  completed 
business  transaction — the  sale  of  goods  by  A  to  B — a  draft 
being  drawn  by  A  against  B,  accepted  by  the  latter,  and 
returned  to  the  former.  Accordingly  when  A  wishes  to  borrow 
from  the  bank  it  is  said  that  all  that  he  needs  to  do  is  to 
present  the  trade  acceptance  for  discount.  But  if  B  lives  in 
a  different  town  from  A  and  from  the  bank,  the  bank,  as  we 
have  seen,  usually  has  little  information  with  reference  to  B's 
financial  standing.  Hence,  if  it  discounts  the  trade  acceptance 
it  will  ordinarily  do  so  only  on  the  basis  of  a  knowledge  of 
A's  financial  standing.  It  cannot  rely  upon  B,  an  unknown 
party,  without  investigation,  and  it  is  much  simpler  as  well 
as  safer  to  rely  upon  A,  a  regular  customer,  well  known  to  the 
bank. 

Now  if  the  bank  were  to  discount  all  of  the  acceptances 
possessed  by  A,  A  would  indeed  be  securing  larger  loans  than 
if  he  borrowed  on  his  single-name  promissory  note,  with  the 
bank  requiring  quick  assets  of  $2  to  every  $1  of  current  lia- 
bilities. But  will  a  conservative  bank  be  willing  to  ignore  the 
ratio  of  quick  assets  to  current  liabilities  in  A's  business,  and 
rely  merely  on  the  fact  that  A  has  sold  goods  to  B  and  has  a 
trade  acceptance  to  show  for  it?  The  answer  is  that  most, 
if  not  all,  of  the  conservatively  managed  banks  of  the  country 
have  recognized  that  to  discount  trade  acceptances  without 
regard  to  the  ratio  of  quick  assets  to  current  liabilities  would  be 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      385 

dangerous  and  that  the  security  for  their  loans  would  be  less 
substantial  than  in  the  case  of  loans  on  single-name  paper. 
While  the  trade  acceptance  may  have  certain  advantages 
from  the  commercial  point  of  view,  it  does  not  possess  the 
advantage  so  vigorously  claimed  for  it  by  most  of  its  pro- 
ponents— that  it  enables  business  men  to  borrow  much  greater 
quantities  of  funds  than  would  otherwise  be  possible.  A 
sufficient  answer  to  the  contention  that  all  businesses,  by  the 
use  of  trade  acceptances,  could  greatly  expand  the  volume  of 
their  working  capital  is  apparent  in  the  fact  that  the  change 
from  one  method  of  financing  credit  operations  to  another  does 
not  increase  the  volume  of  bank  reserves — and  reserves  limit 
the  total  lending  power  of  banking  institutions. 

3.  Loans  secured  by  real  estate  mortgages.  It  has  long  been  a 
contioversial  question  whether  commercial  banks  should  be 
allowed  to  make'  real  estate  loans.  From  the  organization  of 
the  national  banking  system  in  1863  until  19 13  national  banks 
were,  in  fact,  forbidden  to  make  any  loans  on  real  estate  security; 
but  under  the  Federal  Reserve  law  of  1913  the  national  banks, 
except  in  central  reserve  cities,  are  permitted  to  make  such 
loans  to  a  limited  degree.  On  the  other  hand,  the  laws  of 
the  various  states  have  always  permitted  the  making  of  loans 
on  real  estate  security,  and  we  find  from  the  financial  statements 
of  state  banks  that  large  quantities  of  such  loans  are 
characteristically  made.^ 

We  are  not  for  the  present  concerned  with  the  advisability 
of  the  practice  of  making  loans  on  the  security  of  real  estate 
mortgages;  we  are  here  interested  only  in  the  fact.  It  should 
be  noted,  however,  that  real  estate  loans  are  ordinarily  devoted 
to  the  raising  of  funds  for  fixed  capital  requirements. 

4.  Loans  secured  hy  promissory  notes  as  collateral.  Loans 
are  often  made  by  banks  to  individuals  where  the  borrower 
gives  his  own  promissory  note  and  deposits  as  collateral  security 
the  notes  of  other  persons  which  he  holds.  In  case  the  borrower 
does  not  pay  his  note,  the  bank  may  take  possession  of  the 

'  For  further  information  on  this  subject  see  p.  555. 


386         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

collateral  notes  and  collect  the  amount  due  from  the  makers 
thereof.     The  volimie  of  such  loans  is.  however,  relatively  small. 

5.  Loans  secured  by  stocks  and  bonds.  The  great  growth 
of  the  corporation  in  modern  times  and  the  enormous  issue  of 
securities  that  this  has  entailed  have  given  rise  to  a  very  exten- 
sive practice  of  making  loans  on  the  security  of  stocks  and 
bonds  as  collateral.  The  individual  gives  the  bank  a  promis- 
sory note  as  in  the  case  of  an  unsecured  loan;  but,  in  addition, 
he  hypothecates  with  the  bank  stocks  and  bonds,  which  may  be 
sold  by  the  bank  in  the  event  that  the  loan  is  not  paid.  On 
page  387  is  a  copy  of  an  ordinary  promissory  note  with  col- 
lateral agreement. 

The  integrity  of  the  borrower  is  important  even  when  collateral 
is  given.  While  in  making  loans  on  collateral  the  bank  has 
security  to  fall  back  upon  in  case  the  loans  are  not  paid  at 
maturity,  it  nevertheless  cannot  ignore  tte  integrity  and 
honesty  of  the  borrower.  Many  cases  have  arisen  where  a 
dishonest  borrower  has  pledged  securities  to  which  he  had  no 
title,  or  an  imperfect  one;  and  there  are  many  other  ways  in 
which  a  dishonest  or  unscrupulous  individual  may  cause  the 
bank  much  trouble  and  inconvenience,  if  not  actual  loss,  even 
with  collateral  loans.  Accordingly,  bankers  feel  it  necessary 
to  make  a  careful  analysis  of  the  borrower's  general  moral  and 
financial  standing  before  making  collateral  loans. 

There  is  a  difference,  however,  between  a  non-collateral 
and  a  collateral  loan  in  that  in  the  case  of  the  latter  the  bank 
has  an  exclusive  claim  to  assets  which  have  been  deposited 
with  it,  while  in  the  case  of  the  former  it  is  merely  one  of  several 
creditors;  although  it  must  be  remembered  that  where  the 
ratio  of  quick  assets  to  current  liabilities  is  large  the  chance  of 
loss  to  the  bank  is  very  slight  indeed.  In  the  case  of  a  collateral 
loan,  nevertheless,  the  stocks  and  bonds  if  well  selected  can  be 
very  quickly  disposed  of;  whereas  in  case  a  non-collateral  loan 
is  not  paid,  considerable  time  must  ordinarily  elapse  before 
the  bank  can  hope  to  come  into  possession  of  funds. 

Collateral  loans  must  be  protected  by  a  margin  of  value.  In 
order  to  make  sure,  however,  that  the  bank  will  not  suflfer  loss 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      387 


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388         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

when  selling  the  collateral  that  has  been  placed  for  a  loan,  the 
banker  insists  upon  a  margin.  That  is  to  say,  if  a  loan  of 
$100,000  is  secured  by  high  grade,  readily  marketable  bonds, 
the  bank  would  require  the  deposit  of  bonds  the  market  value 
of  which  was  at  the  time,  say,  $110,000.  In  the  case  of  stocks 
the  margin  required  is  ordinarily  considerably  greater  than 
with  bonds;  and  of  course  the  amount  of  margin  that  is  required 
with  any  particular  class  of  bonds  or  stock  will  vary  widely 
depending  upon  the  relative  fluctuations  in  value  of  the  differ- 
ent securities.  It  may  be  observed  that  a  highly  important 
factor  to  consider  is  the  quickness  with  which  such  securities 
can  be  sold.  This  depends  upon  the  number  of  units  that  are 
daily  bought  and  sold  on  the  exchanges. 

Many  collateral  loans  are  made  for  commercial  purposes. 
Loans  on  collateral  owe  their  origin  to  various  circumstances 
Sometimes  collateral  is  required  by  the  bank  because  there  is 
doubt  as  to  the  individual's  ability  to  pay  the  loan  promptly  at 
maturity  from  the  proceeds  of  his  ordinary  business  operations. 
For  instance,  if  the  borrower's  ratio  of  quick  assets  to  current 
liabilities  is  rather  narrow  and  general  conditions  not  particu- 
larly favorable,  the  bank  might  refuse  to  make  an  unsecured 
loan.  But  if  the  individual  had  collateral  to  offer,  the  bank 
could  make  the  loan  with  safety.  In  a  case  such  as  this  the 
funds  borrowed  would  doubtless  be  used  for  commercial 
purposes. 

Collateral  loans  are  sometimes  devoted  to  consumptive  uses. 
Many  collateral  loans  are  also  made  to  individuals  who  are  not 
engaged  in  the  producing,  manufacturing,  or  marketing  of 
goods.  These  individuals  borrow  in  the  main  for  three  purposes : 
consumption,  investment,  and  speculation.  In  the  case  of  a 
consumptive  loan,  the  bank  knows  that  the  employment  of 
the  funds  will  not  directly  result  in  creating  the  means  of 
repaying  the  loan.  The  collateral  deposited  at  the  bank  is 
accordingly  looked  to  as  the  main  security.  If  the  individual 
is  able  to  pay  the  loan  out  of  income  received,  well  and  good; 
if  not,  the  collateral  may  be  sold  by  the  bank  in  settlement  of 
the  obUgation. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      389 

Loans  secured  by  stocks  and  bonds  are  extensively  ttsed  for 
fixed  capital  or  investment  purposes.  Commercial  banks  make 
investment  loans  to  the  investment  .bankers  to  assist  them  in 
connection  with  the  underwriting  and  distributing  of  securities; 
to  individual  investors  who  find  it  necessary  to  borrow  tem- 
porarily a  portion  of  the  funds  required  in  the  making  of  an 
attractive  investment;  and  to  business  men  who  wish  to  use 
the  funds  for  fixed  capital  requirements.  In  all  these  cases, 
the  collateral  protects  the  bank  in  case  the  loans  are  not  paid 
at  maturity,  through  enabling  it  to  obtain  cash  by  the  sale 
of  the  collateral  in  the  securities  markets.' 

It  is  of  interest  to  inquire  why  investment  bankers,  who  are 
engaged  in  the  buying  and  selling  of  securities,  are  required  to 
put  up  collateral  as  a  basis  for  loans,  while  business  men  who 
are  engaged  in  the  buying  and  selling  of  commodities  commonly 
borrow  on  their  single-name  promissory  notes.  It  will  be 
noted  that,  from  the  point  of  view  of  the  investment  banker, 
the  funds  which  he  borrows  provide  him  with  working  capital. 
If  an  investment  banker  borrows  $100,000  with  which  to  buy 
securities,  cannot  the  commercial  banker  rely  upon  the  invest- 
ment banker's  paying  the  loan  at  maturity  out  of  the  proceeds 
derived  from  the  sale  of  the  securities  bought  with  the  borrowed 
capital,  just  as  he  can  rely  upon  a  merchant's  paying  a  loan 
out  of  the  proceeds  of  his  business  ?  The  answer  is,  not  with 
the  same  certainty,  for  the  reason  that  the  security  markets  are 
more  capricious  than  the  commodity  markets.  There  is  less 
certainty  as  to  the  time  at  which  the  sale  will  be  made;  and 
there  is  also  a  greater  chance  of  loss  than  in  the  case  of  ordinary 
manufacturing  and  mercantile  enterprises. 

But  there  is  another  reason  why  collateral  is  ordinarily 
employed  by  the  investment  bankers  in  their  borrowing  opera- 
tions, namely,  because  they  chance  to  have  in  the  securities  in 
which  they  are  dealing  instruments  which  are  in  a  convenient 
form  to  serve  as  collateral.  A  manufacturer  of  raw  materials 
cannot  use  his  raw  materials  as  collateral  for  a  loan  and  at  the 

'  But  for  the  difficulties  which  arise  in  time  of  monetary  stringency  see 
bdow,  pp.  531-33. 


39©         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

same  time  convert  them  into  finished  product;  nor  can  a 
merchant  at  the  same  time  have  his  wares  on  display  and  on 
deposit  as  collateral  with  the  commercial  bank.  And  obviously 
the  bank  could  not  handle  such  collateral.'  But  stocks  and 
bonds  do  not  need  to  be  displayed  in  order  to  be  sold,  and,  by 
virtue  of  their  transferable  and  negotiable  qualities,  they  can  be 
conveniently  deposited  with  the  bank  in  a  collateral  capacity. 
While  investment  bankers  would  doubtless  be  able  to  borrow 
without  collateral  on  the  strength  of  their  reputation  for 
business  integrity  and  ability,  they  find  it  advantageous  to  use 
collateral  because  they  can  usually  borrow  on  more  favorable 
terms  than  they  could  on  unsecured  notes. 

It  remains  to  point  out  that  in  making  loans  to  investment 
bankers  the  commercial  bank  is  in  the  last  analysis  furnishing 
funds  for  fixed  capital  purposes.  While  the  investment  banker 
uses  the  funds  thus  borrowed  as  his  working  capital,  he  of 
necessity  turns  them  over  to  the  corporation  whose  securities 
are  being  marketed.  Thus  all  the  loans  that  we  have  classified 
under  investment  are  devoted  to  fixed  capital  purposes.' 

Collateral  loans  are  also  devoted  to  speculative  purposes .  Specu- 
lative loans  are  of*  two  main  sorts,  those  made  to  real  estate 
and  similar  dealers,  and  those  made  to  traders  on  the  stock 
exchange.  With  both  types  collateral  security  is  practically 
always  required.  In  the  case  of  real  estate  and  similar  loans 
it  may  perhaps  be  asked,  Why  should  collateral  be  required, 
in  view  of  the  fact  that  the  funds  borrowed  are  used  for  working 
capital  purposes,  that  is,  in  the  purchase  of  real  estate  or  other 
commodities  that  are  shortly  to  be  sold  at  a  profit?  Are 
such  operations  not  as  much  commercial  in  their  nature  as  the 
buying  and  selling  of  ordinary  merchandise  ?  The  reason  for 
denoting  such  loans  as  speculative  in  their  nature  is  that  the 
time  at  which  the  sale  will  be  made  is  much  less  certain  than 

'  To  the  extent  that  commodities  serve  as  collateral,  as  we  shall  pres- 
ently see,  it  is  usually  through  the  issue  of  warehouse  receipts  and  bills  of 
lading.     See  pp.  397-400. 

*It  should,  however,  be  recalled  (see  chart  on  p.  136)  that  the  funds 
raised  from  the  sale  of  securities  are  not  exclusively  devoted  to  fixed 
capital  purposes. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      391 

in  the  case  of  ordinary  merchandising;  and  there  is  also  a  greater 
likelihood  of  a  loss  in  connection  with  the  transaction.  Accord- 
ingly, the  bankers  commonly  insist  upon  collateral  security  in 
the  form  of  stocks  and  bonds. 

Stock  exchange  speculation  is  largely  conducted  with  "call" 
loans.  A  discussion  of  the  process  of  loaning  to  stock  exchange 
speculators  requires  first  a  description  of  the  call  loan  system. 
While  a  "call"  loan  is  one  that  is  terminable  at  a  moment's 
notice  at  the  will  of  either  the  borrower  or  the  bank,  in  practice 
such  loans  always  run  at  least  one  day,  payment  on  demand 
meaning  that  they  are  subject  to  call  on  the  day  following. 
There  is  also  a  rule  that»loans  cannot  be  called  by  the  bank  or 
paid  by  the  borrower  after  1:00  p.m.,  unless  notice  has  been 
given  before  that  hour.^ 

The  reason  for  the  development  of  the  call  loan  system 
lies  in  the  nature  of  stock  market  speculation.  An  individual 
who  buys  securities  with  borrowed  funds  does  not  know  at  the 
time  of  the  borrowing  just  when  he  will  be  able  to  pay  the  loan 
for  it  all  depends  upon  the  trend  of  the  market.  If  he  were  to 
contract  a  loan  for  thirty  days,  and  at  the  end  of  four  days 
should  have  sold  his  stock  he  would  find  it  necessary  to  pay 
interest  for  twenty-six  days,  during  which  time  he  might  have 
no  further  use  for  the  money.  The  cost  of  speculation  is 
accordingly  very  greatly  reduced  if  one  is  enabled  to  repay  the 
loan  at  any  time  desired.  The  call  loan  system  also  has  its 
advantages  from  the  viewpoint  of  the  banker.  By  virtue 
of  the  fact  that  a  metropolitan  bank  can  demand  immediate 
payment  of  a  call  loan,  it  does  not  need  to  carry  so  large  a  cash 
reserve  as  would  otherwise  be  the  case.  It  can  keep  its  funds 
more  fully  utilized  and  thereby  increase  its  earning  power.* 

The  interest  rates  on  call  loans  are  subject  to  very  wide 
fluctuations.    They  have  ordinarily  been  lower  than  any  other 

» While  the  only  call  loan  market  in  the  United  States  is  that  in  New 
York,  there  has  recently  been  an  agitation  for  the  establishment  of  one  in 
Chicago. 

*  We  shall  later  see,  however,  that  in  time  of  crisis,  there  are  serious 
weaknesses  in  the  call  loan  system.' 


392  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

rates;  but  on  several  occasions  they  have  gone  beyond  loo 
per  cent.  For  instance,  the  call  loan  rate  rose  to  127  per  cent 
on  October  29,  1896;  to  186  per  cent  on  December  16,  1899; 
and  to  125  per  cent  on  December  28,  1905.  During  the  year 
1919  rates  were  frequently  as  high  as  15  or  20  per  cent,  and  once 
they  reached  30  per  cent.  These  high  rates  occur  at  times 
when  there  is  a  great  dearth  of  loanable  funds  and  a  heavy 
demand  both  for  commercial  and  speculative  purposes.  A 
flurry  on  the  stock  exchange  will  often  give  rise  to  a  very 
great  temporary  demand  for  funds.  The  reason  why  call 
rates  average  lower  than  unsecured  and  collateral  time  loans 
is  that  the  call  loan  funds  are  whaf  may  be  designated  as 
residuary  funds.  The  bank's  first  business  is  tp  take  care  of 
commercial  borrowers  and  others  who  secure  time  loans  on 
collateral.  Funds  not  required  for  these  purposes  are  available 
for  market  operations.  If  the  supply  chances  to  be  fairly 
large,  as  it  normally  is  at  certain  seasons  of  the  year,  the  rates 
will  be  low.  If  the  supply  is  scanty,  the  rates  will  be  high. 
Over  a  period  of  years  the  statistics  show  that  the  supply  of 
funds  for  the  purpose  has  on  the  whole  been  fairly  large.  The 
diagram  on  page  393  indicates  the  average  monthly  rates  in 
the  New  York  money  market  on  dififerent  classes  of  loans  for  a 
period  of  eleven  years,  1896  to  1906,  inclusive.' 

The  making  of  loans  for  stock  market  speculation  is  associ- 
ated with  margin  trading,  discussed  in  chapter  xvi.  We  there 
saw  that  the  individual  who  bought  securities  on  a  margin  paid, 
say,  10  per  cent  down  and  borrowed  the  rest  from  the  broker. 
But  the  broker  is  not  a  banker  and  has  no  funds  of  his  own  to 
lend.  His  ability  to  permit  the  speculator  to  buy  on  a  margin 
is  contingent  upon  his  own  ability  to  borrow  the  funds  from 
his  bank.  To  take  a  concrete  case,  suppose  a  broker  buys 
10,000  shares  of  stock  on  a  10  per  cent  margin  for  a  customer. 
$1,000,000  will  be  required  to  pay  for  the  stock.  The  customer 
advances  $100,000.  Most  of  tlie  remainder  is  borrowed  by  the 
broker  from  the  commercial  bank;   most,  but  not  all,  for  the 

■Taken  from  William  A.  Scott,  "Rates  on  the  New  York  Money 
Market,"  Journal  of  Political  Economy,  XVI,  273-98. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK     393 

reason  that  the  banker  will  not  usually  loan  so  large  an  amount 
as  90  per  cent  of  the  value  of  the  stock,  and  especially  to  a 
broker  who  has  no  funds  of  his  own  on  deposit  with  the  bank. 
Typically  speaking,  a  broker  is  required  to  keep  a  balance 
with  the  bank  equal  to  10  or  15  per  cent  of  the  amount  of  his 
borrowings.  In  the  case  before  us,  therefore,  we  may  assume 
that  the  broker  would  borrow  from  the  bank  $800,000.     Now 

MONEY  RATES  IN  NEW  YORK  CITY 


(^ 


<      S 


3        3 


3 
< 


o     ^ 


B. 
C? 


A  =  Commercial  paper  double  name  6o-day.         B=6o-day  time.         C=Callloan. 

the  $100,000  received  from  the  customer,  plus  the  $800,000 
borrowed  from  the  bank,  taken  in  the  form  of  a  deposit  account, 
plus  $100,000  which  the  broker  already  had  on  deposit  in  the 
bank,  enable  the  broker  to  write  a  check  for  $1,000,000  with 
which  to  buy  the  stock  in  question. 

Loans  to  stockbrokers  are  temporarily  unsecured.  The  broker 
cajmot  buy  the  stock  until  he  has  secured  a  loan  and  he  cannot 
obtain  a  loan  except  on  the  security  of  the  identical  collateral 
which  is  to  be  purchased  with  the  borrowed  funds.  The  way 
out  of  this  dilemma  that  has  been  developed  is  for  the  bank  to 


394         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

certify  a  check  for  $1,000,000  drawn  by  the  broker  against  his 
account  of  $200,000 — a  process  known  as  overcertification. 
With  this  check  the  broker  buys  the  stock  and  then  deposits  it 
as  security  for  the  loan.  It  is  apparent,  therefore,  that  in 
certifying  the  broker's  check  the  bank  has  in  effect  given  him 
temporarily  an  unsecured  loan.  Such  a  practice,  however, 
ordinarily  involves  very  little  risk,  since  a  good  credit  standing 
is  absolutely  indispensable  to  the  broker — a  primary  requisite 
for  success. 

The  practice  of  overcertification  was  long  indulged  in  by 
both  national  and  state  banks.  But  since  it  is  akin  to  an 
ordinary  overdraft  the  practice  was  eventually  frowned  upon 
by  the  Comptroller  of  the  Currency  and  the  national  banks 
have  gradually  abandoned  the  practice,  substituting  therefor 
a  system  of  making  "morning"  loans  to  brokers  for  whatever 
amount  appears  to  be  necessary  for  their  daily  business.  These 
loans  are  based  on  the  single-name  paper  of  the  broker,  that 
is,  on  his  unindorsed  individual  note.  The  only  difference 
between  this  and  overcertification  is  that  with  the  morning 
loan  the  bank  has  the  broker's  written  promise  to  pay,  while  in 
the  case  of  the  overcertification  it  has  not;  both  are  temporarily 
unsecured  loans. 

The  amount  of  overcertification  and  morning  loans  required 
for  stock  market  operations  is  simply  stupendous  in  a  period  of 
active  stock  market  speculation.  In  the  year  1901,  for  instance, 
such  loans  in  New  York  totaled  nearly  $13,000,000,000  for 
stock  transactions  and  another  billion  for  bonds,  an  average  of 
about  $45,000,000  daily. 

6.  Loans  secured  by  bills  of  lading.  Among  the  forms  of 
collateral  available  as  security  for  bank  loans  none  is  more 
interesting  or  more  important  than  the  bill  of  lading.  This 
instrument,  which  is  issued  by  a  transportation  company,  is  of  a 
threefold  character,  that  is,  it  performs  at  once  three  different 
services:  first,  it  is  a  receipt  for  designated  goods,  accepted  for 
shipment  by  the  carrier;  second,  it  is  the  written  evidence  of 
a  contract  to  transport  and  deliver  the  designated  goods  to  a 
designated   person   upon   terms  specified   in   the  instrument; 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      395 

and,  third,  it  is  a  document  of  title  to  the  goods.  The  impor- 
tance of  these  instruments  in  connection  with  banking  operations 
may  be  readily  indicated. 

A  dealer  in  cotton,  grain,  or  merchandise  purchases  goods 
for  sale  in  another  market.  Some  little  time  must  necessarily 
elapse  between  the  date  of  shipment  and  this  receipt  of  funds 
from  the  buyer — the  length  of  time  of  course  varying  with 
the  distance  and  with  the  terms  of  payment.  The  seller, 
however,  usually  needs  the  funds  immediately,  in  order  to  pay 
for  the  produce  which  he  has  just  shipped,  or  to  buy  more,  in 
case  the  present  consignment  has  already  been  paid  for. 
Accordingly,  he  draws  a  draft  upon  the  purchaser  of  the  goods 
and  discounts  this  with  the  local  bank,  turning  over  to  the  bank 
at  the  same  time  the  bill  of  lading  that  has  been  received  from 
the  railroad  company.  The  bank  thus  has  in  its  possession  a 
draft — ^not  yet  accepted — ^and  also  an  instrument  which  bears 
on  its  face  evidence  that  there  has  been  an  actual  shipment  of 
goods  and  which  at  the  same  time  conveys  the  title  of  these 
goods  to  the  banker — for  only  the  holder  of  the  bill  of  lading 
has  the  right  to  demand  the  goods  from  the  railway  company. 

The  bank  sends  the  bill  of  lading,  attached  to  the  draft,  to  a 
correspondent  bank  in  the  city  where  the  buyer  lives.  The 
draft  is  presented  to  the  purchaser  of  the  goods  for  payment, 
in  case  it  is  a  demand  draft,  and  for  acceptance  in  case  it  is  a 
time  draft.  If  the  goods  are  to  be  paid  for  immediately,  the 
bill  of  lading  wiU  of  course  be  surrendered  forthwith  to  the 
buyer  of  the  goods,  who  can  then  secure  their  release  from 
the  railroad  company.  In  the  case  of  a  time  instrument,  it  is 
still  necessary  for  the  buyer  to  get  possession  of  the  goods  if 
he  is  to  use  them  in  his  business.  The  bank  therefore  directs 
that  the  goods  shall  be  delivered  to  the  purchaser,  but  on 
conditions  which  protect  its  interests.*  Both  sellers  and  buyers 
of  goods  thus  borrow  with  bills  of  lading  as  collateral  security: 
the  sellers  during  the  period  while  the  goods  are  in  transit; 
and  the  buyers  for  such  additional  time  as  may  be  necessary. 

»This  ordinarily  involves  the  use  of  a  "trust  receipt."  See  illustra- 
tion on  p.  415  below. 


396         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

There  are  two  kinds  of  bills  of  lading,  classified  from  the 
point  of  view  of  the  ease  with  which  they  may  be  transferred: 
first,  the  straight  bill,  which  states  that  the  goods  are  con- 
signed or  destined  to  a  specified  person;  and  second,  the  order 
bill,  which  is  made  payable  to  the  order  of  some  person.  In 
the  nature  of  the  case,  a  straight  bill  cannot  be  transferred  by 
indorsement,  while  an  order  bill  is  always  thus  "negotiable' 
under  the  federal  Bill  of  Lading  Act,  unless  it  is  specifically 
made  "non-negotiable"  by  the  shipper.  It  should  be  observed 
that  the  transfer  of  order  bills  of  lading  by  indorsement  does 
not  render  them  available  as  substitutes  for  currency;  they  do 
not  possess  all  the  requisites  of  a  fully  negotiable  instrument, 
in  that  they  do  not  call  for  the  payment  of  a  specific  sum  of 
money.  The  purpose  of  giving  them  a  ready  transferability 
by  indorsement  is  to  permit  the  title  to  the  designated  goods 
to  be  easily  passed  from  one  party  to  another,  and  thus  to 
facilitate  the  use  of  these  instruments  as  collateral  for  loans. 

Bills  of  lading  arose  with  the  development  of  transportation; 
and,  as  in  the  case  of  other  instruments,  a  considerable  body  of 
law  has  been  developed  by  our  various  legislative  agencies  for 
facilitating  their  use  in  the  capacities  for  which  they  were 
designed.  The  law  left  much  to  be  desired,  however,  until 
after  the  passage  of  the  federal  Bill  of  Lading  Act,  which  became 
eflFective  January  i,  19 17.  Before  this  time  there  were  many 
irregularities  and  frauds  in  the  use  of  bills  of  lading,  particularly 
in  connection  with  the  shipment  of  cotton  to  Europe.  Indeed, 
it  was  feared  for  a  time,  not  many  years  ago,  that  the  cotton 
frauds,  which  ran  into  millions  of  dollars  annually,  would  imperil 
our  entire  cotton  export  trade.  The  sources  of  loss  to  bankers 
on  bills  of  lading  have  been  enumerated  as  follows:  (i)  the 
issue  of  bills  of  lading  without  the  receipt  of  the  goods;  (2)  the 
delfvery  of  the  goods  to  the  purchaser  without  cancellation 
of  the  bill  of  lading;  (3)  the  alteration  of  bills  of  lading;  (4)  the 
forgery  of  bills  of  lading;  (5)  the  issue  of  duplicate  bills  of 
lading,  the  originals  being  still  outstanding  and  uncanceled. 
The  agitation  for  an  improvement  in  the  law  regulating  bills 
of  lading  finally  became  acute.     It  was  participated  in  by 


PRACTICAL  OPERATIONS  OP  THE  COMMERCIAL  BANK      397 

the  shippers  and  commission  merchants,  by  transportation 
companies,  and  by  the  bankers  of  the  country.  The  interests 
of  these  several  groups  did  not  precisely  coincide  at  all  points, 
but  an  agreement  on  the  main  principles  was  finally  reached, 
and  a  number  of  states  were  led  to  pass  what  was  known  as 
the  Uniform  Bill  of  Lading  Act,  after  which  the  federal  Bill  of 
Lading  law  above  referred  to  was  modeled. 

The  volume  of  business  that  is  financed  on  bills  of  lading 
is  tremendous  in  quantity.  It  has  been  estimated  that  about 
twenty-five  billion  dollars'  worth  of  transactions  now  annually 
involve  their  use,  and  that  about  five  billions  of  this  amount 
are  financed  by  the  commercial  banks.  Bills  of  lading  are 
used  in  connection  with  two  main  classes  of  goods,  as  follows: 
first,  general  merchandise  and  groceries;  second,  commodities, 
such  as  live  stock,  grain,  cotton,  and  perishable  produce.  It 
appears  that  a  very  large  percentage  of  the  business  of  the 
wholesale  grocers  in  the  large  financial  centers,  that  the  bulk 
of  the  business  in  poultry  and  game,  and  about  75  per  cent  of 
the  business  in  the  butter  and  egg  trade  is  handled  on  order 
bills  of  lading. 

On  the  following  page  is  a  copy  of  a  straight  (non- 
negotiable)  bill  of  lading. 

7.  Loans  on  warehouse  receipts.  Another  form  of  borrowing 
is  that  on  the  promissory  note  of  an  individual  secured  by  a 
warehouse  receipt  as  collateral.  As  in  the  case  of  ordinary 
single-name  borrowing,  the  underlying  security  is  goods,  but 
there  is  a  difference  in  that  the  warehouse  receipt  is  issued 
against  specific  goods  held  in  storage;  where  the  ordinary 
single-name  commercial  loan  is  based  upon  the  general  assets 
of  the  borrower,  a  loan  protected  by  a  warehouse  receipt  is 
based  upon  the  specific  assets.  Moreover,  the  holder  of  a 
warehouse  receipt,  like  the  possessor  of  a  bill  of  lading,  has 
control  of  the  disposition  of  the  goods  in  question. 

The  warehouse  receipt  is  employed  as  a  basis  of  credit 
wherever  it  is  convenient  to  do  so.  We  have  already  seen  that 
it  is  impossible  for  a  manufacturer  to  so  use  materials  that  are 
in  process  of  manufacture;  and  that,  similarly,  it  is  usually 


398 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


impossible  for  a  merchant  to  use  his  merchandise  as  collateral 
for  a  loan  for  the  reason  that  it  must  be  on  display.  But 
certain  kinds  of  goods,  notably  whiskey  and  other  beverages 


BILL  OF  LADING 

STRAIGHT  BILL  OF  LADING-ORIGINAL-NOT  NEGOTIABLE. 


Sbipper't  Nq.„ 
Agtau    No. 


SBCBIVE,  anbjRt  to  the  rlmifirtrioM  and  UriA  iu  e&n  on  the  date  of  imc  of  Uiii  Shi|>iiia(  Or<ler, 


miTraiikee.  Wis. 


..¥ar.Rh„ifl^. 


Allls-Chalraers  !.lfp:.      Co 


.19  17, 


-the  property  df«crib«I  below,  ie  app&rent  good  order,  except  aiaotfd 

(cooUsti  ftad  conditioa  of  coatcotfl  of  package*  onknowa),  marked,  conngncd  and  dcatined  as  Indicated  below,  wbkb  »aid  CuiSpaat 

a^eea  to  carry  to  iu  U5ual  place  of  de&Tery  at  said  destisatioa,  if  oa  its  ruad,  otberwise  to  dclirer  *-^ *' ■ -*--   -      -     - 

•aid  destiaation.    It  is  mutually  agreed,  a«  to  eacb  carrier  of  all  or  any  of  said  property  otct  all  or 

natioD,  olJ  aa  to  each  party  at  any  time  interested  in  all  or  any  ofsaid  property,  that  «Tery  acrTice  _  ^ _„  ^^ 

•object  to  all  the  conditicos,  whether  priated  or  written,  licreia  coataiaed  (mciuctijig  cooditiou  oa  back  hcrcol)  aad  whicii  Arc  Agreed  %m 
tf  Uw  thipper  aad  accepted  <or  hinuclf  aod  tus  tnga*^ 


other  carrier  on  the  route  to 
portion  of  iaid  roote  to  dcKf 
be  performed  hereunder  shall  bt 


27m  SaU  of  Fniiht  fre 

" 

fc   .._ 

.. is  in  Ctntt  f 

w  1.00  Lbs. 

IFSftcW 

»«t  •..., 



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imMM 

IFUMtt     IF4tkCU> 

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cooaipied  tolrfing,  Cpatinental  Fretg^'t  .Co. 


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DESeffiPTHMI  CF  ARTICLES  ADO  tPCCIAl  MARKS 

WEIGHT 

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Check 
Colamn 

*V7a  hereby  declue  th«   raht* 

V* 

of  the  property  herein  deecribed 

9 

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fh.                        

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To'be  Prepaid." 

MU^KKn 

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Honolulu  Iron  Works 

ReceWed  $ — _    .... 

Hdtoolulu^  T.H« 

chargM  oa  the  prop«rtjr  dcMrib** 

H.  c.  a  S 

CO                UXIiL 

A«ntf«CMhiw 

•    " •KAHCtUI- 

^POR  CCmsOLIDATlOir^ 

jiiii.9....ch8iMBX8..jfflr«j,...Cft.. 

Pn  H.R.U, 


-Shipper. 


(in  the  past  ?),  grain,  cotton,  hides,  sugar,  canned  goods,  etc., 
are  commonly  held  for  considerable  periods  of  time  in  ware- 
houses; and  receipts  against  such  goods  are  well  adapted  to 
serve  as  collateral  for  loans.     The  warehousing  business  has 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      399 

developed  very  rapidly  in  recent  years  and  accordingly  loans 
on  warehouse  receipts  as  collateral  have  been  rapidly  expand- 
ing in  volume. 

Improving  legislation  is,  moreover,  rapidly  placing  the 
warehousing  business  upon  a  secure  basis.  In  recent  years 
various  states  have  passed  warehousing  laws  and  installed 
systems  of  licensing  and  inspection  so  that  warehouse  receipts 
have  become  among  our  most  reliable  forms  of  commercial 
instruments.  A  United  States  Warehouse  Act  was  also  passed 
on  August  II,  19 16,  which  provides  for  the  issuance  of  licenses 
by  the  Secretary  of  Agriculture  for  the  operation  of  warehouses 
for  the  storage  of  agricultural  products.  The  Hcense  brings  the 
operation  of  the  warehouse  under  an  inspection  service  of 
the  Department  of  Agriculture  and  makes  it  incumbent  upon 
the  owner  of  the  warehouse  to  give  bonds  for  the  faithful 
discharge  of  his  obligations  to  the  owners  of  commodities  placed 
in  his  custody.  The  inspection  service  includes  an  examination 
of  the  warehouse  before  the  license  is  issued,  and  from  time  to 
time  thereafter,  together  with  an  examination  of  the  competency 
of  the  warehouseman  in  classifying,  weighing,  and  certifying 
the  produce  received. 

Every  warehouse  receipt  issued  under  this  law  shall  state 
the  following  things:  (a)  location  of  warehouse;  (b)  date  of 
issue;  (c)  consecutive  number;  (d)  to  whom  deUverable; 
(e)  rate  of  storage  charges;  (/)  description  of  products;  (g)  grade 
or  other  class;  (h)  that  it  i%  issued  under  the  United  States 
Warehouse  Act;  {i)  the  interest  of  warehouseman,  if  any; 
(j)  advances  and  liabilities  for  which  warehouseman  claims 
a  lien. 

Warehouse  receipts,  like  bills  of  lading,  are  documents  of 
title  to  the  goods  in  storage.  They  are  sometimes  negotiable 
and  sometimes  not,  depending  upon  the  conditions  under 
which  they  are  issued.  Like  bills  of  lading,  however,  they  are 
not  substitutes  for  currency  and  do  not  embody  all  the  requisites 
of  a  full-fledged  negotiable  instrument;  they  do  not  call  for 
pa3anent  in  money,  for  example,  but  only  for  the  delivery  of 
certain  specified  goods. 


400         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Below  is  a  copy  of  an  ordinary  "negotiable"  warehouse 
receipt. 

WAREHOUSE  RECEIPT 


DOE  WAREHOUSE.  Receipt  No 

. I  Bute.)        ~*  *'^ 

Vndk«  the  L*ir«  or Paid  w  Cawtal'Stock  >.. 

WAREHOUSE   RECEIPT 

FOR 

ONE  BALE   OF   COTTON 

of on 

arebouK  located  at , 


subject  to  the  conditions  h<Teinaft<^r  set  out.    Said  bale  of  cotton  u  identilied  bv  the  tag  numbers  and  marka,  and,  subject  to  reasonable 
vanationa  and  coocMled  defectt,  i»  of  the  weijcht.  f^ade  (according  to  the  official  cotton  standards  of  the  United  SUtee,  uolen  expreoaljr 
Mated  otherwise),  length  of  staple,  and  coDdition  wt  out  below. 
Tao  No Maaks Weight Grade Lingtb  or  Stapli Condition 


^sacdtUBlf....UDd«ilMit«raDd «zpawdl4>tbtwMtbOT.  W)di«  fully  inturedscftinst 

^Tte  Dot  WwAouw  d^.au^i  bra  on  !»'1w*MOJot^«««,  aAiaaeramtaf. 

diaujyto '. flrUxnlsr: 


SSfSr:;;::;:: 


aAwuwa,  and  UsbUitks  tbMMn,  ttw  ootUo  daaolbed  bmin  wQl  ba  d«Uv«r«d  Lnuim- 
(SIffsd).. 


0  Cstm  Wwahous*  SyslMi.  P« 


With  bills  of  lading  and  warehouse  receipts  as  security,  as 
with  stocks  and  bonds,  the  bank  usually  requires  a  margin  of 
safety.  That  is  to  say,  on  a  bill  of  lading  or  warehouse  receipt 
of  high  standing  and  against  a  commodity  which  is  not  subject 
to  wide  fluctuations  in  value,  such  as  grain  and  cotton,  the 
bank  may  loan  as  high  as  90  or  95  per  cent  of  the  market  value 
of  the  produce  against  which  the  receipt  is  issued. 

It  may  also  be  pointed  out  that  the  giving  of  collateral 
in  the  form  of  a  bill  of  lading  or  warehouse  receipt  is  not  required 
by  the  bank  on  the  ground  that,  the  loan  would  otherwise  be 
unsafe.  Indeed  the  business  out  of  which  warehouse  receipts 
and  bills  of  lading  grow  is  essentially  commercial  in  its  nature. 
The  use  of  the  warehouse  receipt  and  bill  of  lading  as  collateral 
for  loans  is  mainly  attributable  to  their  convenience  for  the 
purpose,  and  to  the  fact  that  through  their  hypothecation  as 
collateral  security  the  borrower  is  enabled  to  secure  somewhat 
larger  advances  than  would  otherwise  be  the  case.  Indeed, 
produce  dealers  are  commonly  granted  large  loans  on  their 
single-name  notes — granted  a  "line  of  credit";  and  it  is  only 
when  loans  in  excess  of  this  amount  are  desired  that  the  collateral 
is  required. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      401 

8.  Investments  in  stocks,  bonds,  short-term  notes,  mortgages, 
etc.  Investments  in  securities  are  not  listed  among  the  types 
of  loans  in  the  table  on  page  377.  An  investment,  however, 
does  represent  a  loan  of  funds  quite  as  truly  as  any  of  the 
lending  operatipns  that  we  have  been  discussing,  the  only  real 
difference  being  the  length  of  time  for  which  the  credit  is 
extended. 

In  general,  it  may  be  said  that  the  investments  of  commer- 
cial banks  in  stocks  are  negligible  in  amount.  Because  of 
the  wide  fluctuations  to  which  stock  values  are  subject,  it  is 
regarded  as  bad  banking  practice  to  hold  shares,  except  tem- 
porarily, as  a  means  of  salvaging  bad  debts.  But  most  com- 
mercial banks  have  long  followed  the  practice  of  investing  a 
considerable  portion  of  their  assets  in  high-grade  bonds,  and 
to  a  lesser  degree  in  mortgages,  warrants,  etc.  The  following 
table  shows  the  amount  and  character  of  bond  and  stock 
investment  holdings  of  the  national  and  state  banks  of  the 
United  States  in  1916: 

INVESTMENTS  OF  COMMERCIAL  BANKS 
(In  thousands  of  dollars) 

ALL  NATIONAL  BANKS* 

United  States  bonds* $731,205 

State,  county,  and  municipal  bonds 278,180 

Railroad  bonds 467,629 

Other  public-service  corporation  bonds 274,928 

All  Other  bonds 301,503 

Claim  warrants 43, 818 

Judgments 4,703 

Foreign  government  securities 116,768 

Other  foreign  securities 40,303 

Stocks 39,272 

Total $2,298,309 

*  These  are,  of  course,  mainly  held  as  security  for  note  issoes. 

^Report  of  the  Comptroller  of  the  Currency  (1916),  pp.  166-69. 


402         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY     ' 

15,450  STAfE  BANKS' 

United  States  bonds $    1,311 

State,  county,  and  municipal  bonds 3i>440 

Railroads 2,cx)6 

Bonds  of  other  public-service  corporations  (including 

street  and  interurban  railway  bonds) .     .     ,     ,     .  14,809 

Other  bonds,  stocks,  warrants,  etc. 643,721 

Total $693,287 

The  figures  for  later  years  would  show  a  much  greater 
volume  of  government  bond  investments,  as  a  result  of  the 
exigencies  of  war  finance.  An  attempt  is  now  being  made, 
however,  to  reduce  the  total  of  bank  investments  in  govern- 
ment bonds  by  encouraging  their  absorption  by  the  general 
investing  public. 

In  this  chapter  we  have  merely  been  presenting  the  facts 
as  to  the  nature  of  commercial  bank  loans  and  investments; 
there  has  been  no  attempt  to  consider  the  wisdom  of  this  or 
that  particular  type  of  credit  extension,  or  the  results  of  the 
loan  policy  of  banks  upon  the  safety  and  efficiency  of  the  com- 
mercial banking  system  in  general.  These  issues  will  be  con- 
sidered in  subsequent  chapters. 

QUESTIONS  FOR  DISCUSSION 

I.      GENERAL  CONSmERATIONS 

1.  Are  the  banks  of  your  community  national  or  state  institutions  ? 
Ascertain  by  local  inquiry  why  they  were  organized  under  state 
or  national  law,  as  the  case  may  be. 

2.  Are  there  any  private  banks  in  your  community?  If  so,  are 
they  subject  to  state  supervision  of  any  kind  ? 

3.  Enumerate  as  many  ways  as  you  can  in  which  the  commercial 
banks  of  your  community  render  services  to  their  customers. 
Which  do  you  regard  as  of  greatest  importance  ? 

4.  Do  you  keep  your  own  financial  accounts  by  means  of  a  check 
book  and  a  monthly  bank  statement  ?    If  not,  why  not  ? 

•  Report  of  the  Comptroller  of  the  Currency  (1916),  p.  852. 


I>RACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK     403 

n.      ANALYSIS  OF  COMMERCIAL  BANKING   OPERATIONS 

5.  What  is  the  difference  between  loans  and  discounts?  "All 
discounts  are  loans  but  not  all  loans  are  discounts."  Explain 
this  statement. 

6.  What  is  the  difference  between  bank  and  true  discount  ?  Figure 
the  bank  and  the  true  discount  respectively  on  $100,000  at 
6  per  cent  for  three  months. 

7.  What  is  an  overdraft  ?    Why  is  it  listed  as  an  asset  ? 

8.  In  what  different  ways  do  commercial  bank  deposits  arise? 
Which  is  the  more  common  ? 

9.  It  is  sometimes  stated  that  a  commercial  bank  lends  out  the 
funds  of  its  depositors.  Do  you  think  this  is  an  accurate  and 
adequate  statement  of  the  nature  of  commercial  banking 
operations  ? 

TO.  "The  commercial  bank  acts  as  an  intermediary  between  lenders 
and  borrowers.  It  collects  funds  from  certain  people  and  lends 
them  to  others. "    Do  you  agree  ? 

11.  "The  commercial  bank  assembles  cash  resources  from  original 
capital  contributions,  from  earnings,  and  from  (cash)  deposits, 
and  on  the  basis  of  these  cash  resources  it  makes  loans  and  creates 
deposit  accounts. "    Do  you  agree  ? 

Note. — This  aspect  of  commercial  banking  will  be  more  fully  dis- 
cussed in  chapter  xxii.  The  student's  conclusion  at  this  place  should 
therefore  be  only  tentative. 

12.  Indicate  the  changes  in  a  commercial  bank's  balance  sheet  that 
would  result  from  the  following  operations,  using  +  or  —  signs 
as  in  the  problem  on  page  354  above: 

a)  Discount  a  promissory  note  of  $100,000  for  two  months  at 
6  per  cent.  Assume  that  the  borrower  does  not  wish  to 
withdraw  his  funds  in  actual  cash. 

b)  Assume  that  a  depositor  writes  three  checks  against  his 
account,  each  for  $30,000;  one  of  them  is  deposited  in  this 
bank;  one  in  another  bank  in  the  same  community;  and  the 
third  in  a  bank  in  another  town. 

c)  The  loan  made  in  (c)  above  is  paid  at  maturity  in  the  following 
manner:  (i)  one-half  by  check  against  the  borrower's  account 
in  this  bank ;  (2)  one-eighth  by  a  certified  check  of  a  depositor 
in  this  bank;  (3)  one-eighth  by  a  cashier's  check  on  another 
bank  in  the  same  city;    (4)  one-eighth  by  a  bank  draft  on 


404         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

New  York;    (5)  one-sixteenth  by  notes  of  this  bank;   and 
(6)  one-sixteenth  by  cash. 

d)  Receive  a  deposit  of  $25,000  composed  of  the  following  items: 
(i)  $5,000  in  cash;  (2)  $5,000  in  checks  on  other  banks, 
members  of  the  same  clearing  house;  (3)  $5,000  in  drafts  on 
an  out-of-town  bank;  (4)  $5,000  in  notes  of  other  national 
banks;  and  (5)  $5,000  in  checks  on  this  bank. 

e)  Make  a  loan  of  $10,000  to  Mr.  X  in  the  form  of  an  issue  of 
bank  notes.  Assume  the  price  of  2  per  cent  government 
bonds  to  be  $101. 

0  Purchase  $10,000  in  bonds,  paying  for  them  by  cashier's 
checks. 

g)  Declare  a  semi-annual  dividend  (using  the  figures  in  the 
Continental  and  Commercial  National  Bank  statement  on 
p.  365  above)  of  10  per  cent,  crediting  one-half  of  the  amount 
to  the  accounts  of  stock-holding  depositors  and  paying  the 
remainder  by  drafts  on  New  York.  Carry  the  remainder  of 
the  undivided  profits  account  to  siurplus. 

13.  In  which  class  of  national  banks  do  you  find  note  issue  of  relatively 
greatest  importance?  least  importance?  (See  table  on  p.  372.) 
How  do  you  explain  this  ? 

14.  How  do  you  explain  the  relative  decrease  in  the  volume  of 
national  bank  notes  in  all  classes  of  banks  between  1870  and  1909  ? 
Who  determines  in  practice  whether  a  bank  shall  issue  notes  or 
create  deposits  when  making  a  loan  ? 

m.      ANALYSIS   OF  COMMERCIAL   BANK   LOANS 

d)  The  Various  Types  of  Loans 

15.  "The  pivotal  thing  in  sound  banking  is  the  character  of  a  bank's 
loans."    Why? 

16.  Which  is  the  more  significant  classification  of  bank  loans,  by 
time  or  by  the  character  of  the  security  ? 

17.  Study  the  classification  of  bank  loans  on  page  377  and  draw  up  a 
statement  of  the  points  of  significance  and  interest. 

18.  What  is  the  meaning  of  the  last  two  items  in  this  classification 
of  loans  ? 

19.  X,  a  real  estate  dealer,  borrows  $10,000  from  a  bank  for  three 
months,  giving  as  security  a  mortgage  on  real  estate  which  he 
purchases  with  the  money.  Is  this  a  commercial,  investment, 
or  speculative  loan  ? 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      405 

20.  X  Railroad  Company  borrows  $100,000  from  a  bank  on  six 
months'  time,  giving  the  bank  its  unsecured  promissory  note: 
(a)  the  company  uses  the  funds  in  buying  equipment;  (b)  the 
funds  are  used  for  meeting  operating  expenses.  Is  this,  in  each 
case,  a  commercial  or  an  investment  loan  ? 

21.  Would  it  make  any  difference  in  the  preceding  example  if  the 
loan  were  secured  by  collateral  ? 

22.  A  bank  lends  a  lawyer  $1,000  for  two  months  on  his  single-name 
promissory  note.  Is  this  a  commercial,  speculative,  or  invest- 
ment loan?  Suppose  the  note  were  indorsed:  would  this 
change  its  nature  ?    What  if  collateral  were  required  ? 

23.  J.  P.  Morgan  &  Company  borrows  $100,000  from  a  bank  for 
three  months,  putting  up  stocks  and  bonds  as  collateral.  Is 
this  an  investment,  speculative,  or  commercial  loan  ?  Are  the 
fimds  used  as  working  or  fixed  capital  by  J.  P.  Morgan  &  Com- 
pany ?    What  is  the  ultimate  disposition  of  the  funds  ? 

24.  A  manxifacturer  borrows  for  three  months  $20,000  with  which  to 
buy  raw  material,  giving  his  unsecured  note  to  the  bank.  Is 
this  a  commercial  or  an  investment  loan  ? 

25.  A  producer  of  raw  materials  borrows  for  ninety  days  $20,000 
and  uses  the  funds  to  meet  pay-rolls.  Is  this  commercial  or 
investment  borrowing  ? 

26.  A  wholesaler  discounts  at  his  bank  a  trade  acceptance,  due  in 
sixty  days.    Is  this  an  investment  or  a  commercial  loan  ? 

27.  A  retailer  borrows  $10,000  from  a  bank  on  his  single-name 
promissory  note /or  three  months  and  uses  the  funds  in  erecting 
an  addition  to  his  store.  Is  this  a  commercial  or  an  investment 
loan?  Would  you  hold  that  a  commercial  bank  should  never 
make  such  a  loan  without  collateral  security  ? 

28.  A  bank  makes  a  loan  to  an  individual  who  uses  the  money  in 
perfecting  an  invention  on  which  he  hopes  to  reaUze  a  fortune. 
How  would  you  classify  such  a  loan  ? 

29.  A  bank  loans  money  to  a  man  who  is  a  promotor  of  industrial 
combinations.    How  would  you  classify  such  a  loan  ? 

30.  What  sort  of  loan  would  you  call  one  to  a  country  preacher? 
to  a  new  doctor  in  a  small  town  ? 

31.  What  are  "character  loans"? 

32.  How  would  you  classify  a  loan  made  to  a  broker  on  the  stock 
exchange  ? 


4o6         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

SS.  Would  you  regard  a  loan  to  the  son  of  a  retired  merchant  on  the 
basis  of  his  father's  good  reputation  a  safe  loan  ?  Would  it  be 
wise  to  make  many  such  loans  ?    Should  collateral  be  required  ? 

34.  Is  the  significant  element  in  a  "commercial"  loan  the  short 
duration  or  the  use  to  which  the  funds  are  put  ? 

35-  Why  are  commercial  loans  commonly  of  short  duration  ?  Strictly 
speaking,  what  principle  should  govern  their  duration  ? 

Note. — The  student  should  reserve  final  judgment  on  this  question 
until  after  he  has  studied  chapter  xxiii,  particularly  pages  532-33. 

b)  Single-Name  versus  Double-Name  Paper 

36.  In  the  case  of  a  loan  on  a  single-name  promissory  note,  who  owns 
the  hote  ?    Who  owns  an  indorsed  note  ? 

37.  Who  owns  notes  that  are  deposited  as  collateral  for  loans  ? 

38.  X  brings  to  the  bank  a  promissory  note  of  Y  and  indorses  it 
over  to  the  bank.  As  a  banker,  would  you  base  your  confidence 
that  the  loan  would  be  paid  on  X  or  on  Y  ?  Which  one  is  pri- 
marily liable  ? 

39.  Which  woiJd  you  prefer  to  have,  an  indorsed  promissory  note 
or  trade  acceptance  arising  from  a  specific  and  already  con- 
siunmated  sale  of  goods  from  X  to  Y,  or  a  single-name  promissory 
note  of  X  who  presents  a  financial  statement  showing  total 
quick  assets  equal  to  four  times  the  total  current  Uabilities? 

40.  In  general  do  you  see  any  inherent  advantage  in  basing  a  loan 
on  a  specific  transaction  of  a  given  business  man,  rather  than  on 
his  transactions  in  general,  as  revealed  by  his  financial  statement 
and  profit  and  loss  accounts  ?    If  so,  what  ^ 

41.  Classify,  in  the  order  of  their  importance,  the  various  sources  of 
credit  information  that  are  available  to  a  bank. 

42.  What  is  the  supposed  especial  advantage  of  loans  on  trade 
acceptances?  Is  a  trade  acceptance  superior  in  any  way  to  a 
trade  note  ? 

43.  As  a  banker,  would  you  discount  trade  acceptances,  without 
regard  to  the  general  financial  standing  of  the  borrower  ? 

c)  Loans  on  Collateral 

44.  Who  owns  the  collateral  during  the  life  of  the  loan  ? 

45.  In  what  respects  is  mortgage  collateral  inferior  to  bonds  and 
stocks  ? 

46.  Why  are  not  promissory  notes  more  commonly  used  as  collateral 
for  bank  loans  ? 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      407 

47.  Name  as  many  reasons  as  you  can  why  collateral  may  be  required. 

48.  In  the  case  of  loans  to  investment  bankers  and  stock  exchange 
operators,  is  collateral  security  indispensable  to  a  safe  extension 
of  credit  ? 

49.  Indicate  the  changes  on  a  bank's  balance  sheet  that  would  result 
from  the  following  collateral  loaning  operations: 

a)  A  loan  of  $40,000  for  three  months  at  6  per  cent  is  made  on  the 
basis  of  collateral  composed  of  bonds  and  stock,  the  margin 
being  20  per  cent. 

b)  The  foregoing  loan  is  paid  at  maturity  by  a  check  on  this 
bank.  Meanwhile  the  value  of  the  collateral  had  shrunk 
until  the  margin  was  only  10  per  cent. 

c)  The  bank  makes  a  $50,000  call  loan,  the  call  rate  at  the 
moment  being  6  per  cent.  Collateral  is  deposited  with  a 
market  value  of  $60,000. 

d)  The  bank  calls  the  foregoing  loan  (c)  and  the  broker  is  unable 
to  pay,  whereupon  the  bank  sells  the  collateral  for  $55,000, 
receiving  in  payment  a  check  on  another  bank  in  New  York. 
The  loan  had  run  for  thirty  days,  and  the  call  rate  during 
this  period  had  averaged  8  per  cent. 

50.  What  governs  the  rates  on  call  money  ?  How  do  they  compare 
at  present  with  other  rates  ? 

51.  How  is  it  ever  possible  for  an  individual  to  pay  as  much  as 
100  per  cent  for  the  use  of  money  ? 

52.  How  can  banks  afford  to  accept  only  2  or  3  per  cent  on  money 
loaned  at  call  ?    Are  they  not  losing  on  such  money  ? 

53.  What  is  the  difference  between  the  demand  loans  of  banks  out- 
side of  New  York  and  the  call  loans  in  New  York  ? 

54.  How  do  you  account  for  the  different  rates  on  the  different 
types  of  loans,  as  shown  by  the  chart  on  page  393  ? 

55.  What  is  the  purpose  of  overcertification ?  of  "morning  loans"? 
Are  the  latter  any  safer  than  overcertification  ? 

56.  How  large  a  margin  should  be  required  with  the  following  col' 
lateral:  (a)  unlisted  common  stock  of  a  good  substantial  concern  ? 
(b)  listed  preferred  stocks  of  an  industrial  corporation  ?  (c)  rail- 
road bonds  ?  (d)  municipal  bonds  ?  (e)  grain  warehouse  receipts  ? 

57.  What  is  meant  by  "mixed"  collateral?  Is  there  any  advantage 
in  it? 

58.  Do  you  see  any  objectioil  tQ  ffia^iflg  collateral  loans  for  ^ed 
capital  purposes  ? 


4o8         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

59.  In  what  respects  does  a  bill  of  lading  diflfer  from  other  collateral  ? 

60.  Would  you  prefer  a  bill  of  lading  as  collateral  to  stocks  and 
bonds  ?    Why,  or  why  not  ? 

61.  Could  produce  dealers  and  others  who  borrow  on  bills  of  lading 
as  collateral  not  obtain  loans  on  their  unsecured  notes? 

62.  As  a  banker,  would  you  grant  loans  more  readily  and  for  larger 
amoimts  where  bills  of  lading  were  given  as  security  ?  Why,  or 
why  not  ? 

63.  In  what  respects  does  a  warehouse  receipt  differ  from  securities 
as  collateral  ? 

64.  As  a  banker,  would  you  refuse  to  lend  to,  say,  a  produce  dealer 
except  ufKjn  the  dep)osit  of  a  warehouse  receipt  as  collateral? 

65.  Woxold  you  lend  a  larger  sum  with  than  without  a  warehouse 
receipt  as  collateral  ?    Would  you  grant  any  lower  rates  ? 

66.  Do  you  think  it  probable  that  warehouse  receipts  and  bills  of 
lading  are  used  as  collateral  whenever  they  are  available  for  the 
purpose  ?    Why,  or  why  not  ? 

d)  Investments  of  Commercial  Banks 

67.  Study  the  financial  statement  of  your  local  banks  and  ascertain 
how  many  different  types  of  investments  they  holdi 

68.  In  what  respects  are  bonds  better  investments  for  commercial 
banks  than  stocks  ?  than  mortgages  ? 

69.  In  what  respects  are  short-term  notes  superior  as  bank  invest- 
ments to  bonds  ? 

70.  Why  are  United  States  certificates  of  indebtedness  a  popular 
form  of  bank  investment  ? 

71.  Why  are  bonds  with  an  early  maturity  date  regarded  as  par- 
ticularly desirable  types  of  bond  investments  for  commercial 
banks? 

72.  Do  you  see  any  general  disadvantage  in  investments  as  compared 
with  collateral  loans  ? 

73.  Would  you  support  the  doctrine  that  commercial  banks  should 
not  invest  in  securities  and  thereby  furnish  funds  for  fixed 
capital  purposes  ? 

Note. — ^Flnal  judgment  on  this  issue  should  be  reserved  until 
after  reading  chapter  xziii. 


PRACTICAL  OPERATIONS  OF  THE  COMMERCIAL  BANK      409 

REFERENCES  FOR  FURTHER  READING 

Agger,  Eugene  E. :  Organized  Banking,  chap.  i. 

Dunbar,  Charles  F.:  Chapters  in  the  History  and  Theory  of 
Banking,  3d  edition,  revised  and  enlarged  by  O.  M.  W.  Sprague, 
chaps,  ii  and  iii. 

Holdsworth,  John  Thom:  Money  and  Banking,  chap,  viii,  x 
andxvi. 

Kniffin,  WiUiam  H. :  The  Practical  Work  of  a  Bank,  chap.  xiii. 

Moulton,  Harold  G.:  Principles  of  Money  and  Banking,  Part  II, 
chap.  iv. 

Phillips,  Chester  A.:  Readings  in  Money  and  Banking,  chap.  ix. 

Scott,  WiUiam  A.:  Money  and  Banking,  chap.  vii. 

Shaw  Banking  Series:  Credits  and  Collections,  chaps,  vi,  vii 
and  viii. 

White,  Horace:   Money  and  Banking,  Book  III,  chap.  ii. 

Willis,  H.  Parker:  American  Banking,  chap.  xiii. 


CHAPTER  XX 

COMMERCIAL  BANKING  AND  THE  FINAN- 
CING OF  FOREIGN  TRADE 

In  the  foregoing  discussion  of  the  practical  operations  of 
commercial  banks,  the  analysis  related  primarily  to  the  part 
these  institutions  play  in  financing  local  or  domestic  business 
requirements.  In  the  present  chapter  our  attention  will  be 
specifically  directed  to  the  relations  of  commercial  banks  to 
the  financing  of  foreign  commerce  and  industry.  - 

I.    FINANCING  IMPORT  TRADE 

In  illustrating  the  principles  of  foreign  exchange  in  chapter 
viii  it  was  pointed  out  that  the  American  exporter  customarily 
draws  a  bill  of  exchange  on  a  London  importer,  or  on  a  bank 
designated  by  him,  and  then  offers  the  bill  for  sale  in  the  New 
York  market.  It  has,  however,  not  been  true  that  the  British 
exporter  to  this  country  commonly  draws  a  bill  upon  the  New 
York  importer,  or  a  designated  bank,  and  offers  this  bill  for 
sale  in  London.  The  practice  has  rather  been  for  the  American 
importer  to  buy  a  sterling  bill  of  exchange  from  an  American 
bank  and  remit  this  in  payment,  or  for  the  foreign  exporter  to 
draw  a  draft  against  a  London  bank  rather  than  against  a  New 
York  institution.  In  considering  the  part  that  commercial 
banks  play  in  the  financing  of  import  trade,  we  must  therefore 
first  consider  the  reasons  for  the  common  practice  of  drawing 
these  bills  on  London  rather  than  on  New  York. 

Until  after  the  adoption  of  the  Federal  Reserve  System  in 
1913  United  States  banks  were  not  permitted  to  accept  drafts 
diawn  against  them.  Now  a  British  exporter  would  not 
draw  on  an  individual  in  New  York  because  of  the  difficulty 
in  disposing  of  such  a  bill  at  a  reasonable  rate — unless  the 

4x0 


COMMERCIAL  BANKING  AND  FOREIGN  TRADE       41 1 

individual  importer  chanced  to  have  an  international  reputa- 
tion. It  was  accordingly  much  cheaper  for  the  exporter  to 
receive  a  bill  drawn  on  a  London  bank;  for  this  could  be 
promptly  discounted  at  a  low  rate  in  the  London  discount 
market.  And  even  were  a  draft  accepted  by  an  American 
importer  of  international  reputation,  it  could  still  not  be 
discounted  in  the  London  market  on  as  favorable  terms  as 
London  bills.  Through  the  use  of  London  bills  the  British 
exporter  was,  moreover,  enabled  to  avoid  the  "  risk  of  exchange, " 
that  is,  changes  in  the  rate  of  exchange  between  the  two  coun- 
tries; for  if  he  possessed  a  British  bill,  payable  in  sterling  in 
London,  subsequent  changes  in  the  rate  of  exchange  would  not 
affect  the  volume  of  funds  which  he  would  receive. 

Commercial  letters  of  credit  are  widely  used  in  financing 
imports.  The  financing  of  import  trade  is  typically  eflFected 
through  the  use  of  an  extremely  interesting  financial  device, 
developed  during  the  last  twenty-five  years,  and  known  as  the 
commercial  letter  of  credit.  A  concrete  illustration  will  reveal 
the  nature  of  this  form  of  credit  operation. 

Suppose  an  importer  in  New  York  desires  to  buy  $10,000 
worth  of  silk  from  a  firm  in  Hongkong.  The  American  importer 
is  not  known  to  the  Chinese  exporting  house  and  it  is  out  of 
the  question  for  the  Chinese  exporter  to  draw  a  bill  of  exchange 
upon  the  New  York  importer  and  secure  the  funds  by  dis- 
counting the  bill  at  a  Hongkong  bank.  Moreover,  since  the 
importer's  credit  standing  is  unknown  to  the  Hongkong 
merchant,  the  latter  cannot  well  afford  to  take  the  chance  of 
shipping  the  goods  oh  credit  and  waiting,  say,  six  months  for 
payment.  An  arrangement  is  therefore  made  whereby  the 
credit  of  the  New  York  house  is,  in  a  sense,  guaranteed  by  a 
financial  institution  in  which  the  Hongkong  exporter  may 
have  confidence. 

The  New  York  importer  goes  to  his  banker  and  secures  a 
commercial  letter  of  credit.  The  letter  of  credit  is  addressed 
to  the  exporter,  and  it  authorizes  a  bank,  say,  in  London,  to 
accept  the  six-months  sight  drafts  of  the  Hongkong  exporter 
of  silk  up  to  a  certain  total  sum  and  under  certain  prescribed 


412         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

conditions,  pertaining  to  the  attaching  to  the  draft  of  bills  of 
lading,  insurance  certificates,  etc.,  these  terms  all  being  set 
forth  in  the  letter  of  credit.  The  banker  in  London  is  of 
course  notified  that  the  letter  of  credit  has  been  issued.  The 
letter  of  credit  itseK  is  sent  to  the  Hongkong  exporter.  Not 
until  the  receipt  of  this  letter  of  credit,  which  (when  confirmed 
by  the  London  bank)  assures  him  that  a  responsible  financial 
house  is  willing  to  accept  drafts  drawn  upon  it  and  specifies 
the  terms  on  which  the  goods  are  to  be  shipped,  does  the  Chinese 
exporter  proceed  with  the  shipment  of  the  silk. 

As  soon  as  the  goods  have  been  shipped,  the  exporter  draws 
a  bill  of  exchange  on  the  London  bank,  pins  to  it  the  bill  of 
lading  and  the  insurance  certificate,  and  then  takes  the  draft 
to  his  local  bank  in  Hongkong,  where  it  is  discounted.  The 
whole  transaction  is  then  closed  so  far  as  the  exporter  is  con- 
cerned. It  may  be  added  that  the  Hongkong  bank  will  have 
no  hesitation  in  buying  the  draft,  because  it  can  either  sell  it  to 
Chinese  importers  who  must  make  remittances  to  London  or 
send  it  to  London  directly  for  collection.  It  may  be  added, 
also,  that  the  development  of  the  American  acceptance  market 
would  not  necessarily  lead  to  a  general  practice  of  drawing  on 
American  banks  in  this  connection,  for  the  reason  that  American 
bills  would  not  be  in  active  demand  in  Hongkong,  the  financial 
relations  of  which  are  primarily  with  England,  and  also  because 
of  the  lower  discount  rate  that  characteristically  obtains  in  the 
London  market. 

The  goods  are  meanwhile  on  the  way  to  New  York.  The 
draft,  with  biU  of  lading  and  insurance  certificate  attached, 
is  now  sent  by  the  Hongkong  bank  to  its  correspondent  bank 
in  London,  which  presents  it  to  the  bank  that  has  agreed  to 
accept  it.  It  is  accepted  and  marked  payable  at  a  definite 
date,  say,  April  i.  When  the  draft  is  accepted,  the  bill  of 
lading  and  insurance  certificate  are  detached  (in  case  it  is  a 
"documents  acceptance"  as  distinguished  from  a  "docu- 
ments payment"  instrument),  the  accepted  bill  is  returned  to 
the  bank  that  presented  it,  and  the  bill  of  lading  and  insurance 
certificate  are  sent  to  the  New  York  bank  which  originally 


COMMERCIAL  BANKING  AND  FOREIGN  TRADE       413 

arranged  the  commercial  letter  of  credit.  It  may  be  noted 
that  the  accepted  draft  (bank  acceptance)  may  be  sold  by  the 
bank  which  has  it  in  its  possession  to  other  banks  in  London, 
or  to  individuals  desiring  high-grade  short-term  investments. 
In  fact,  such  an  acceptance  often  changes  hands  many  times 
during  the  interval  between  the  date  of  acceptance  and  the 
date  upon  which  it  is  due. 

By  the  time  the  bill  of  lading  and  insurance  certificate 
have  reached  the  bank  in  New  York,  the  consignment  of  goods 
may  also  have  arrived  there.  The  New  York  bank  there- 
fore turns  the  bill  of  lading  and  insurance  certificate  over  to  the 
importer  of  the  silk,  thus  permitting  the  importer  to  secure 
the  release  of  the  goods  and  offer  them  for  sale.'  It  will  be 
noted  that  unless  the  individual  can  secure  possession  of  the 
goods  he  cannot  sell  them,  and  if  he  cannot  sell  them,  he  cannot 
well  turn  over  to  the  bank  with  which  the  letter  of  credit  has 
been  arranged  the  funds  necessary  to  pay  the  London  dis- 
counting bank.  For  it  must  be  remembered  that  in  the  last 
analysis  it  is  the  importer  who  does  pay  for  the  goods.  Con- 
cretely the  process  of  payment  is  as  follows: 

The  importing  house  pays  to  the  New  York  bank  $10,000 
some  time  before  April  i.  The  New  York  bank  turns  these 
funds  over  to  the  London  accepting  bank  before  April  i.  On 
April  I  the  London  accepting  bank  pays  $10,000  to  whatever 
individual  or  bank  may  present  the  bill  for  payment.  It  will 
be  seen,  however,  that  if  the  importer  fails  to  put  the  bank  in 
funds  before  it  has  to  remit  to  London,  the  New  York  bank 
will  have  to  advance  the  funds  out  of  its  own  resources.  And, 
in  turn,  if  the  London  bank  did  not  receive  funds  from  its  New 
York  correspondent  before  April  i,  it  would  have  to  pay  the 
bill  out  of  its  resources.  Both  banks,  therefore,  assume  some 
risk;  and  as  compensation  each  receives  a  commission,  the 
amount  varying,  but  commonly  being  from  one-foiurth  to  one- 
half  of  I  per  cent  of  the  amount  of  the  bill  for  every  thirty 
days  that  it  runs. 

'In  the  case  of  long  shipments  duplicate  documents  are  oft«i  sent 
direct  to  New  York,  in  order  that  the  importer  may  not  be  delayed  in 
obtaining  possession  of  the  goods. 


414         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

It  will  be  seen  that  after  the  London  bank  parted  with  the 
bill  of  lading  and  insurance  certificate  it  possessed  no  document 
of  title  to  the  goods;  it  merely  relied  upon  the  good  faith  of 
its  New  York  correspondent.  Here  is  credit  in  its  most  highly 
developed  form. 

In  turn,  when  the  New  York  bank  turned  the  bill  of  lading 
over  to  the  importer  it  no  longer  possessed  title  to  the  goods. 
An  arrangement  has  been  developed,  however,  whereby  the 
banker  does  have  more  than  an  unsecured  promise  to  pay, 
even  though  he  parts  with  the  bill  of  lading  which  constitutes 
the  title  to  the  goods.  For  when  the  bill  of  lading  is  offered 
to  the  importer,  he  gives  to  the  bank  a  "trust  receipt,"  which 
states  that  he  has  received  the  merchandise  and  that  he  will 
sell  the  goods  and  turn  the  proceeds  over  to  the  bank  before 
or  at  maturity  of  the  bill  of  exchange.  Trust  receipts  are  of 
various  sorts;  but  it  is  usual  for  them  to  specify  that  the 
merchandise  is  to  be  kept  separate  from  other  merchandise 
held  by  the  firm,  and  that  the  specific  funds  derived  from  the 
sale  of  the  goods  are  to  be  turned  over  to  the  bank.  On  the 
accompanying  page  is  a  copy  of  a  typical  trust  receipt.  The 
"letter  of  credit  agreement"  also  includes  provisions  designed 
to  protect  the  interests  of  the  bank.     (See  copy  on  p.  416.) 

American  banks  can  now  accept  ^^ dollar"  import  drafts.  The 
Federal  Reserve  Act  of  1 913,  as  amended,  authorizes  national 
banks  of  the  United  States  to  accept  drafts  drawn  for  the 
purpose  of  financing  both  imports  and  exports,'  and  accord- 
ingly the  process  of  financing  imports  has  entered  upon  a  new 
phase.  Instead  of  drawing  bills  of  exchange  against  London 
banks,  it  is  now  possible  to  draw  "dollar  drafts,"  that  is, 
drafts  against  American  banks  and  expressed  in  terms  of 
dollars.  It  is  believed  that  the  practice  of  drawing  upon 
American  rather  than  foreign  banks  will  gradually  increase. 
On  page  417  is  a  copy  of  a  dollar  "import  letter  of  credit." 

*  New  York  state  banking  legislation  shortly  fell  into  line  with  the 
Federal  Reserve  Act  and  authorized  state  bank  acceptances. 


TRUST  RECEIPT. 


RECEIVED  from  the  Guaranty  Trust  Co.  of  New  York  the  following 
goods  and  merchandise,  their  property,  specified  in  the  Bill  of  liading  per 

S.  S Dated 

marked  and  numbered  as  follows: 


and,  in  consideration  thereof,  ■( }  herebt  agree  to  hold  said  goods  in 

we   J 

trust  for  them,  and  as  their  property,  with  liberty  to  sell  the  same  for  their 
account,  and  further  agree,  in  case  of  sale  to  hand  the  proceeds  to  them  to 
apply  against  the  acceptances  of  the  Guaranty  Trust  Co.  of  New  York  on 

f  my  1 

< \  account,  under  the  terms  of  the  Letter  of  Credit  No., issued 

[  our  J 

f  iny 

for  i [    account  and  for  the  payrhent  of  any  other  indebtedness  of 

[  our 
mine 

to  the  Guaranty  Trust  Co.  of  New  York. 


ours 

The  Guaranty  Trust  Co.  of. New  York  may  at  any  time  cancel  this 
trust  and  take  possession  of  said  goods,  or  of  the  proceeds  of  such  of  the  same 
as  may  then  have  been  sold,  wherever  the  said  goods  or  proceeds  may  then 
be  found  and  in  the  event  of  any  suspension,  or  failure,  or  assignment  for  the 
my   1 

benefit  of  creditors,  on  \  j-  part,  or  of  the  non-fulfillment  of  any  obli- 

our  J 


gation,  or  of  the  non-payment  at  maturity  of  any  acceptance  made  by 


under  said  credit,  or  under  any  other  credit  issued  by  the  Guaranty  Trust 
my  ~ 

account  or  of  any  indebtedness  on  ■ 


{^1 

Y  Trust 

-I 

I  our  J 


Co.  of  New  York  on  ^ 

our 
part  to  them,  all  obligations,  acceptances,  indebtedness  and  liabilities  what- 
soever shall  thereupon  (with  or  without  notice)  mature  and  become  due  and 

r  my  1 
payable.    The  said  goods  while  in  <  >  hands  shall  be  fully  insured  against 

[  our  J     • 
loss  by  fire. 

Dated,  New  York  City, , .191 

(Signed) 

X Stg. 


4l6         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

LETTER  OF  CREDIT  AGREEMENT 
To  the  NATIONAL  BANK  OF  THE  REPUBLIC. 

Chicago^ 


Gentlemen: 

Having  received  from  you  Letter  of  Credit  No ___ 

for __ 

OH copy  of  which  is  herewith  annexed hereby 

agree  to  its  terms  and  in  consideration  thereof  bind lo  reimburse 

you  for  any  draft  or  drafts  drawn  thereunder,^^ days  prior 

to  maturity  thereof,  at  the  current  rate  of  exchange  for  first-class  Bankers'  Bills.     It  is 

understood  that  the  commission  for  accepting  under  this  credit  is  to  be per  cent. 

-         hereby  give  you  a  specific  claim  and  lien  on  all  goods  or  merchandise 

{and  the  proceeds  thereof)  for  which  you  may  have  paid  or  come  under  any  engagements 

under  this  credit,  and  on  all  policies  of  insurance  (which^ agree  to  effect) 

on  such  goods  or  merchandise  to  an  amount  sufficient  to  cover  your  advances  or  engage 
mentt  under  this  credit,  and  on  all  bills  of  lading  given  for  same,  with  full  power  and 
authority  to  take  possession  and  dispose  of  the  same  at  discretion,  for  your  security  or 
reimbursement,  and  to  charge  all  expenses  including  commission  for  sale  and  guarantee. 
^*"f  furfhpr  agree  to  give  you  any  additional  security  that  may  be  demanded. 

And further  pledge  to  you  as  security  for  any  other  indebtedness 

of to  you,  any  surplus  that  may  remain,  either  in  goods  or  the  proceeds 

thereof  ajter  providing  for  the  acceptance  under  this  credit,  .ffe  further  authorise  you  to 
cancel  this  letter  of  credit  at  any  time  to  the  extent  it  shall  not  have  been  acted  upon  when 
notice  of  revocation  is  received  by  the  user.  This  obligation  is  to  continue  in  force  an  J  to 
be  applicable  to  all  transactions,  notwithstanding  any  change  in  the  individuals  composing 
the-  respective  firms,  parties  to  this  contract,  or  either  of  them,  or  in  that  of  the  user  of  this 
credit,  whether  such  change  shall  arise  from  the  accession  of  one  or  more  new  partners,  or 
from  the  death  or  secession  of  any  partner  or  partneru 
Yours  respectfully. 


COMMERCIAL  BANKING  AND  FOREIGN  TRADE       417 
Import  Leittr  o£  Credit  (Dollars) 


Credit  No._i?i2fI—  Guaranty  Trust  Company  of  New  York 

Foreign  Department 
$100,000— U\S.C. 

New  York.   .         F^^rylt,19l9 

Messrs.  John  Doe  &  Company, 


Yokohama,  Japan 


At  ihe  request  and  for  the  account  of      ^/^^^^-  Jo^r^on  Crawford  &  Cofnyany,  New  York 

we  hereby  authorize  you  to  value  on 

Guaranty  Trust  Company  of  New  York,  New  York 
at F'"^  (4)  Months  sight j^^  ^jjg  g^^,  q^  gums  not  exceeding  a  total  of 


One  hundred  thnusand  dollars  (9100,000) . 

accompanied  by  commercial  invoice,  consular  invoice,  bills  of  lading    Marine  and  war-risk,  in- 

surance  cerlijirMes  •  

r^pry^fnting          cost,  insurance  and  freight         sMpm^nt  »f    Raw  Silk  from  Yokohama.  Japan,  to 
New  York 

Insurance  Marine  and  war-risk  insurance  to  be  effected  by  the  shippers 

BiUs  of  lading  for  such  sUpments  must  be  drawn  to  the  order  pf    Guaranty  Tr^M  Company  of 
New  York,  New  York 

A   COPY   OF  THE   CONSULAR   INVOICE   AND   ONE  BILL  OF  LADING  MUST  BE  SENT  BY  THE  BANK 
NEGOTIATING  DRAFTS,  DIRECT  TO  GUARANTY  TRUST  COMPANY  OF  NEW  YORK,  NEW  YORK. 

The  amount  of  each -draft  negotiated  must  be  endorsed  hereon. 

We  hereby  agree  with  bona  fide  holders  that  all  drafts  drawn  by  virtue  of  this  Credit,  and  in 
accordance  with  the  above  stipulated  terms,  shall  meet  with  duejionor  upon  presentation  at  the 

Guaranty  Trust  Company  of  New  York,  New  York,  if  drawn  and  negotiated  prior  to      ^^     ' 

1919 

Guaranty  Trust  Company  of  New  York 


N.  B.  Drafts  drawn  under  this  Credit  must  bear 
the  clause  "drawn  under  Letter  of  Credit 
Ttf^       1S4S67      pa^^  February  n,  1919" 


4l8         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

n.    FINANCING  EXPORT  TRADE 

Before  the  establishment  of  the  Federal  Reserve  System, 
foreign  banks,  particularly  those  of  London,  played  a  dominant 
part  in  the  financing  of  our  export  trade.  An  exporter  of 
wheat  from  the  United  States  under  a  letter  of  credit  charac- 
teristically drew  a  bill  of  exchange  on  an  English  bank — a  bank 
that  had  been  designated  by  the  importer  of  the  grain.  This 
accepting  bank  charged  the  importer  a  commission  for  the 
loan  of  its  name;  and  the  British  banks  which  have  specialized 
in  this  acceptance  business  have  found  it  a  source  of  remimera- 
tion  that  has  long  been  coveted  by  American  bankers. 

It  should  be  noted  that  while  the  bill  of  exchange  was 
drawn  against  a  foreign  bank,  the  seller  of  the  grain,  in  case  he 
desired  his  funds  immediately,  took  the  draft,  with  bill  of 
lading  and  other  shipping  documents  attached,  to  his  bank  in 
New  York  or  Chicago  and  had  it  discounted.  While  American 
banks  thus  first  advanced  the  funds,  the  bills  were  typically 
soon  sent  to  London  where  they  were  carried  by  London 
banks  which  henceforth  received  the  interest  thereon. 

The  use  of  "dollar"  export  letters  of  credit  is  developing. 
With  the  authorization  to  American  banks  to  engage  in  the 
acceptance  of  bills  drawn  for  both  import  and  export  purposes, 
it  has  become  possible  for  American  banks  to  supplant  foreign 
institutions  as  acceptors  of  bills,  both  in  the  case  of  direct  sales 
to  Great  Britain  and  of  shipments  to  South  America,  or  else- 
where. Suppose  A  in  Chicago  sells  goods  to  B  in  London  and 
requests  B  to  arrange  it  so  that  the  bill  may  be  drawn  against 
a  New  York  rather  than  a  London  bank.  The  buyer  in  London 
accordingly  goes  to  his  London  bank  and  asks  the  bank  to  open 
for  him  a  dollar  credit  with  some  New  York  institution.  If 
the  credit  standing  of  the  British  importer  is  satisfactory, 
the  bank  will  agree  to  arrange  a  dollar  credit  with  its  corre- 
spondent bank  in  New  York.  It  thereupon  writes  or  cables 
to  its  correspondent  in  New  York  asking  that  a  credit  be 
opened  for,  say,  $10,000  in  favor  of  A,  a  Chicago  exporter. 
In  this  arrangement  the  terms  on  which  the  exporter  is  to  be 


COMMERCIAL  BANKING  AND  FOREIGN  TRADE       419 

allowed  to  draw  upon  the  New  York  bank  are  set  forth  and 
the  documents  that  accompany  the  draft  are  designated.  As 
soon  as  the  exporter  has  been  notified  that  a  credit  has  been 
arranged  with  a  New  York  bank,  he  draws  a  draft  for  $10,000 
on  the  New  York  bank,  and  then  discounts  it  at  his  local  bank. 
The  Chicago  bank  in  turn  sends  the  draft  to  New  York  for 
payment.  The  attached  documents  are  then  sent  by  the 
New  York  bank  to  its  correspondent  in  London,  which  turns 
them  over  to  the  importer  in  order  that  the  goods  may  be 
claimed  and  released. 

The  bill  in  these  cases  may  be  a  sight  draft,  in  which  case  it 
is  paid  before  the  documents  are  given  up.  But  if  it  is  a  time 
bill  payable,  say,  in  sixty  days,  it  is  obvious  that  the  London 
bank  in  parting  with  the  bill  of  lading  is  running  some  risk  of 
loss.  If  the  bank  has  any  doubt  as  to  the  credit  standing  of 
the  importer,  it  will  retain  control  of  the  merchandise  as  security 
and  parcel  it  out  to  the  importer  as  partial  payments  on  the 
amount  due  are  made — ^in  accordance  with  the  terms  of  a 
trust  receipt  or,  it  may  be,  merely  on  terms  laid  down  in  the 
letter  of  hypothecation. 

It  will  be  noted  that  in  this  case  both  the  London  and  the 
New  York  banks  receive  commissions  for  services  rendered: 
the  London  bank  for  arranging  with  its  correspondent  in  New 
York  to  accept  the  draft,  and  the  New  York  bank  for  its 
service  as  acceptor.  In  general,  it  may  be  said  that  the  com- 
missions are  about  equally  divided  between  the  British  and 
the  American  banks.  The  size  of  the  commissions  of  course 
varies  in  different  cases,  depending  upon  the  risks  involved 
and  the  length  of  the  credit  extended. 

Similarly,  in  financing  trade  transactions  between  the 
United  States  and  South  America,  it  is  no  longer  necessary  to 
call  upon  a  London  banking  house  to  accept  the  drafts  drawn 
under  letters  of  credit.  They  may  now  be  drawn  directly  upon 
American  banking  institutions.  In  this  connection  there  has 
arisen  a  particularly  interesting  use  of  the  commercial  letter  of 
credit,  known  as  the  system  of  "re-financing."  Let  us  assume 
that  X  in  New  York  has  sold  structural  materials  of  iron  and 


420         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

steel  to  Y  in  Uruguay.  Since  the  foreign  exchange  facilities 
between  Uruguay  and  New  York  are  not  well  developed,  it 
would  be  practically  out  of  the  question  for  the  importer  in 
Uruguay  to  buy  in  Montevideo  a  draft  drawn  in  dollars,  which 
he  could  send  to  X  in  payment.  And  since  there  are  few 
banking  facilities  in  Uruguay,  it  is  also  not  practicable  for  the 
American  exporter  to  draw  a  draft  upon  a  designated  Monte- 
video bank.  At  the  same  time,  it  will  be  seen  that  a  draft 
drawn  against  the  importer  in  Uruguay  could  not  readily  be 
discounted  in  New  York.  Accordingly,  the  exporter  arranges 
with  a  New  York  bank  an  export  letter  of  credit,  under  which 
he  may  draw  a  draft  upon  the  New  York  bank. 

The  distinguishing  feature  of  this  operation  is  that  it 
involves  the  drawing  of  two  bills  of  exchange,  the  one  a  trade 
draft  and  the  other  a  bank  draft.  Concretely,  the  exporter 
first  draws  a  mercantile  bill  of  exchange  on  the  importer  in 
Uruguay.  This  instrument,  together  with  the  bill  of  lading 
and  other  shipping  documents,  is  turned  over  to  the  New  York 
bank  which  arranges  the  export  credit,  and  is  then  forwarded 
with  the  shipping  documents  to  Uruguay.  Meanwhile,  a 
second  draft  is  drawn  by  the  exporter  upon  the  New  York 
bank,  as  a  means  of  enabling  the  seller  of  the  goods  to  obtain 
immediate  command  of  funds.  It  may  be  noted,  also,  that 
the  bank  draft  runs  for  a  somewhat  longer  period  than  the  mer- 
cantile instrument,  the  purpose  of  this  being  to  insure  ample 
time  to  receive  from  Uruguay  the  fujids  which  the  New  York 
bank  uses  in  meeting  at  maturity  the  draft  which  it  has 
accepted. 

//  is  argued  that  the  use  of  dollar  exchange  will  encourage 
export  trade.  The  drawing  of  dollar  credit,  it  is  said,  will 
enable  the  American  exporter  to  avoid  paying  commissions  and 
shift  this  burden  to  the  foreign  importer.  This  common 
argument,  however,  overlooks  the  fact  that  the  question  of 
commissions  is  usually  ironed  out  in  the  terms  of  contract 
between  exporter  and  importer.  While  it  may  appear  to  the 
exporter  that  the  use  of  dollar  drafts  relieves  him  of  commission 
charges,  such  is  not  necessarily  the  case. 


COMMERCIAL  BANKING  AND  FOREIGN  TRADE       421 

There  is  more  point  to  the  argument  that  the  use  of  dollar 
exchange  will  encourage  foreign  export  trade  through  simplifying 
the  financial  side  of  the  operation  for  the  American  dealer. 
While  the  development  of  foreign  exchange  faciUties  by  Ameri- 
can banks  in  the  last  twenty  years  has  made  it  possible  for  any- 
one who  knows  the  ropes  readily  to  arrange  export  letters  of 
credit  and  to  discount  with  banks  the  bills  of  exchange  drawn 
against  foreign  banks,  many  American  business  men  desirous 
of  engaging  in  export  trade  are  not  familiar  with  the  foreign 
exchange  mechanism  and  they  accordingly  hesitate  to  enter 
into  operations  which  involve  perplexing  exchange  computa- 
tions. When  bills  are  drawn  in  dollars,  however,  the  exporter 
knows  exactly  where  he  stands;  he  is  dealing  with  his  own 
money;  he  feels  on  certain  ground.  Moreover,  the  arrange- 
ment does  enable  him  to  shift  the  "risks  of  exchange"  to  the 
foreign  importer. 

The  Federal  Reserve  Act  authorized  the  establishment  of 
foreign  branches  of  American  hanks.  The  authorization  of 
dollar  acceptances  by  the  Federal  Reserve  Act  was  calculated, 
as  already  noted,  to  encourage  foreign  trade.  It  was  felt, 
however,  that  our  foreign  trade,  particularly  that  with  South 
America  and  other  relatively  undeveloped  countries,  would  be 
further  facilitated  by  granting  permission  to  American  banks 
to  establish  branches  in  foreign  countries.  Accordingly, 
authorization  was  given  under  the  Federal  Reserve  law  for 
the  development  of  foreign  branch  banking. 

That  the  absence  of  legislation  authorizing  foreign  branch 
banks  is  not,  however,  the  sole  cause  of  our  restricted  exports  to 
South  America  and  other  countries  may  be  seen  from  the  fact 
that  under  the  laws  of  various  states  it  has  long  been  possible  for 
state  banks  to  estabUsh  branches  abroad;  and  private  banking 
houses  have  always  been  able  to  establish  such  foreign  agencies, 
some  private  banking  houses  having  in  fact  done  so. 

While  the  advantages  of  developing  branches  of  American 
banks  in  foreign  countries  have  no  doubt  been  greatly  exag- 
gerated, it  is  nevertheless  true  that  the  expansion  of  our  foreign 
trade  would  be  expedited  in  some  degree  by  the  development 


422         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

of  American  banking  facilities  abroad.  The  intimate  asso- 
ciation of  the  branch  bank  managers  with  business  men  and 
importers  in  foreign  countries,  together  with  the  acquisition  of 
knowledge  on  the  part  of  American  bankers  of  the  credit 
standing  of  foreign  buyers,  are  matters  of  first  importance  in 
developing  overseas  trade  and  will  no  doubt  improve  our 
opportunities  for  a  lucrative  expansion  of  our  foreign  business. 

m.    THE  EDGE  LAW  AND  THE  FINANCING  OF 
FOREIGN  TRADE 

There  was  in  fact  a  considerable  expansion  of  American 
banking  in  foreign  countries  following  the  authorization  of 
branch  banks  by  the  Federal  Reserve  Act  of  1913.  The 
facilities  provided  by  the  law  were,  however,  felt  to  be  inade- 
quate to  meet  the  needs  of  post-war  foreign  financing.  Accord- 
ingly the  Edge  Act  of  December,  1919,  has  added  some  new 
features  to  our  system  of  financing  foreign  trade.  While  the 
Federal  Reserve  Act  merely  made  it  possible  for  existing 
national  banks  to  establish  foreign  branches,  the  Edge  law 
provides  for  the  organization  of  a  new  type  of  financial  cor- 
poration— a  specialist  in  foreign  trade  and  finance. 

The  features  of  the  Edge  law  which  relate  to  the  furnishing 
of  fixed  capital  to  foreign  countries  through  the  purchase  of 
foreign  securities  by  institutions  modeled  after  the  foreign 
investment  trust  have  been  considered  in  chapter  xvi.  We 
need  therefore  consider  here  only  the  provisions  of  this  law 
which  relate  to  the  financing  of  ordinary  shipments  of  goods 
abroad. 

The  general  banking  powers  of  the  corporations  authorized 
under  the  provisions  of  the  Edge  law  are  as  follows:  (i)  to 
purchase,  sell,  discount,  and  negotiate,  with  or  without  their 
indorsement  or  guaranty,  notes,  drafts,  checks,  bills  of  exchange, 
acceptances,  including  bankers'  acceptances,  cable  transfers, 
and  other  evidences  of  indebtedness;  (2)  to  accept  bills  and 
drafts  drawn  upon  them  subject  to  such  restrictions  as  the 
Federal  Reserve  Board  may  impose;  (3)  to  issue  letters  of 
credit;    (4)  to  purchase  and  sell  coin,  bullion,  and  exchange; 


COMMERCIAL  BANKING  AND  FOREIGN  TRADE       423 

(5)  to  borrow  and  lend  money;  (6)  to  receive  deposits  outside 
of  the  United  States,  and  only  such  deposits  within  the  United 
States  as  may  be  incidental  to,  or  for  the  purpose  of,  carrying 
out  transactions  in  foreign  countries,  or  dependencies,  or 
insular  possessions  of  the  United  States;  (7)  to  exercise  such 
powers  in  general  as  are  incidental  to  those  conferred  by  the  law, 
or  such  ....  as  may  be  usual  in  connection  with  the  trans- 
action of  the  business  of  banking  or  other  financial  operations 
in  foreign  countries,  colonies,  etc. 

Finally,  these  corporations  are  authorized,  under  prescribed 
regulations,  to  establish  and  maintain,  for  the  transaction  of 
their  business,  branches  and  agencies  in  foreign  countries  and 
in  the  dependencies  or  insular  possessions  of  the  United 
States,  at  such  places  as  may  be  approved  by  the  Federal 
Reserve  Board. 

Up  to  the  present  time'  only  one  company  appears  to  have 
been  organized  under  the  Edge  law,  namely  the  First  Federal 
Foreign  Banking  Association.  This  association  has  been 
formed  by  a  group  of  New  York  financial  interests  and  manu- 
facturers engaged  in  export  tiade.  Under  the  plan  of  operation 
fhe  manufacturer  sells  his  products  abroad  on  long-term  credit. 
The  foreign  buyers  give  their  notes  to  the  Foreign  Banking 
.Association,  and  the  latter  sells  its  own  debentures,  or  notes, 
secured  by  the  foreign  paper  as  collateral,  and  turns  the  proceeds 
over  to  the  exporter.  It  is  the  plan  to  sell  these  securities  in 
the  localities  where  the  exported  products  are  manufactured, 
an  appeal  being  made  for  their  purchase  as  a  means  of  pro- 
moting the  industrial  activity  of  the  district. 

• 

IV.    CONCLUSION 

It  remains  to  be  seen  to  what  extent  these  various  measures 
will  be  efifective  in  expanding  the  volume  of  our  foreign  trade, 
and  in  strengthening  the  position  of  New  York  in  the  field  of 
international  finance.  The  use  of  dollar  drafts  has  already 
gained  some  momentum,  the  development  having  been  given 
an  impetus  in  consequence  of  the  enormous  war  demands  of 
Europe  for  American  goods.    Owing  to  this  rapid  development, 

'  August,  IQ20. 


424         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

many  people  have  been  led  to  believe  that  New  York  bids 
fair  soon  to  rival  London  as  a  financial  center  engaged  in 
the  acceptance  of  international  bills  of  exchange.  Those  who 
hold  this  view,  however,  are  usually  not  particularly  well 
informed  as  to  the  principles  governing  international  trade  and 
financial  operations.  Just  as  there  is  a  prevalent  misunder- 
standing of  the  importance  of  foreign  trade,  particularly  of 
the' so-called  "balance  of  trade,"  and  just  as  there  is  a  funda- 
mental misconception  on  the  part  of  most  people  as  to  the 
advantage  of  obtaining  a  creditor  position  among  nations, 
so  also  the  benefits  to  be  obtained  from  the  development  of  insti- 
tutions for  financing  foreign  trade  are  grossly  exaggerated. 
The  problem  is  stated  by  one  leading  student  of  international 
trade  and  finance  in  the  following  language:' 

In  current  discussions  of  foreign  trade  and  of  the  use  of  the 
acceptance,  it  is  often  assumed  that  foreign  trade  can  be  financed 
simply  as  a  result  of  current  sales  and  purchases.  From  this  it 
naturally  follows  that  if  appropriate  banking  machinery  be  available 
to  carry  the  trade,  there  would  be  little  difficulty  in  securing  a  satis- 
factory development  of  the  business.  This  assumption,  however, 
is  not  in  accord  with  the  facts  of  modern  international  commerce. 
International  trade  is  not  carried  on  upon  a  money  basis,  but  in 
many  countries  payment  for  large  quantities  of  staple  purchases  is 
made  in  the  form  of  securities  based  on  the  enterprises  in  which  the 
goods  thus  bought  are  employed.  For  example,  shipments  of  steel 
rails  to  China  for  the  construction  of  the  railways  of  that  country 
have  been  paid  for  in  bonds  which  have  been  taken  by  banking 
concerns  in  the  country  which  sold  the  rails,  and  then  have  been 
transferred  to  the  investors,  who,  in  the  last  analysis,  supply  the 
ntbney.  Similar  methods  of  financing  have  been  adopted  in  dealing 
with  Brazil,  and  with  other  South  American  countries  where  trade 
grew  up  on  a  basis  of  borrowed  capital.  While  trade  between  older 
nations,  as,  for  example,  France  and  Germany,  is  not  necessarily 
founded  upon  international  loans  of  this  kind,  they  nevertheless 
figure  to  a  considerable  extent.  Capitalists  in  one  coimtry  are 
constantly  looking  for  openings  in  another,  and  a  general  interchange 
of  securities  has  resulted.  From  this  it  follows  that,  as  a  rule,  the 
country  which  exports  to  another  is  obliged  to  provide  capital  for 

'  H.  Park;r  Willis,  The  Federal  Reserve,  pp.  292-95. 


COMMERCIAL  BANKING  AND  FOREIGN  TRADE       425 

the  development  of  business  in  that  other.  In  South  America,  for 
example,  there  will  be  little  development  of  American  trade  unless 
the  United  States  is  willing  to  supply  the  capital  for  the  financing 
of  enterprises  on  a  long-time  basis.  Even  in  those  classes  of  opera- 
tions which  are  not  founded  on  bonds,  it  is  frequently  necessary  that 
banks  should  stand  ready  to  finance  the  trade  by  carrying  the  mer- 
chants who  are  conducting  it  during  a  crop  period,  instead  of  expect- 
ing to  be  paid  immediately  upon  arrival  of  the  goods.  In  other 
words,  foreign  operations  are  not  exclusively  of  a  banking  nature, 
but  are  also  financial  in  the  larger  sense  of  the  term. 

The  plain  conclusion  to  be  drawn  from  the  state  of  things  just 
described  is  that  although  the  Federal  Reserve  Act  has  provided  the 
mechanism  for  conducting  foreign  trade  by  permitting  the  organiza- 
tion of  branches  of  national  banks,  and  although  it  has  furnished  a 
means  for  bringing  the  banking  paper  of  the  United  States  into 
harmony  with  that  of  other  countries  through  the  introduction  of 
the  acceptance,  there  is  no  reason  why  international  banking  should 
be  developed  by  Americans  very  much  more  largely  than  at  present, 
pending  the  time  when  the  United  States  is  ready  to  furnish  the 
capital  that  is  needed  by  business  men  and  producers  in  the  countries 
with  which  trade  is  being  built  up. 

While  it  was  believed  that  this  handicap  to  export  trade 
would  in  large  measure  be  overcome  by  means  of  the  financing 
corporations  authorized  by  the  Edge  Act,  it  should  be  observed 
that  the  ability  of  the  United  States  to  participate  extensively 
in  furnishing  the  investment  funds  required  by  foreign  countries 
is  limited  by  the  conditions  outhned  in  chapter  xv,  and  also  by 
the  condition  of  our  own  investment  market  and  of  the  reserves 
of  our  commercial  banking  institutions.  These  will  be  dis- 
cussed at  some  length  in  chapter  xxvi. 

QUESTIONS  FOR  DISCUSSION 

1.  How  do  you  account  for  the  importance  of  London  in  the  field 
of  international  finance?  Do  you  think  the  adoption  of  the 
single  gold  standard  at  as  early  a  date  as  18 16  has  had  anything 
to  do  with  it  ? 

2.  Can  you  think  of  any  good  reason  why  American  banks  should 
not  have  been  allowed  to  accept  bills  of  exchange  until  very 
recently  ? 


426         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

t .  Why  should  the  London  discount  rate  be  characteristically  very 
low? 

4.  Using  the  import  letter  of  credit  case  given  in  the  text,  show  just 
how  each  party  to  the  transaction  makes  a  profit  and  how  each 
is  reimbursed  for  funds  advanced  ? 

5.  Read  the  copy  of  the  "dollar"  import  letter  of  credit  on  page  417, 
and  then  show  how  the  American  bank  in  question  would  finance 
an  imp>ortation  from  the  Japanese  firm  named  in  the  instrument. 

6.  Do  you  think  the  trust  receipt  is  of  any  especial  importance? 
Would  the  bank  accept  the  drafts  if  it  had  not  found  by  investi- 
gation that  the  importer  was  good  for  the  amount  ? 

7.  Is  it  important  that  the  bank  should  have  a  claim  to  the  specific 
goods  ?  Answer  this  in  the  light  of  the  discussion  in  the  preceding 
chapter  of  the  various  ways  of  extending  credit. 

8.  Why  would  not  an  American  exporter  to  Uruguay  draw  a  draft 
on  a  bank  in  Montevideo  ? 

9.  Could  not  the  importer  in  Uruguay  Ray  for  his  goods  by  means 
of  a  bill  of  exchange  on  London  ? 

10.  Is  it  of  any  particular  advantage  to  the  United  States  to  have  its 
own  banks  do  its  own  financing  ?  Do  you  object  to  our  paying 
toll  to  London  ?  Answer  in  the  Ught  of  your  knowledge  of  the 
principles  of  international  exchange. 

11.  "Every  bank  created  abroad  is  the  pioneer  of  national  industry 
and  the  initial  step  in  iminterrupted  relations  between  the 
foreign  country  in  question  and  the  United  States."  Do  you 
agree  ? 

12.  "There  exist  at  Rio  de  Janeiro  three  German  banks  who  support 
their  compatriots,  facilitate  their  business,  and  form  a  valuable 
aid  to  German  trade.  In  face  of  an  obsciu*e  French  and  Italian 
bank  only  the  haughty  Transatlantic  German  Bank  is  capable  of 
competing  in  prestige  with  the  famous  bank  of  London. "  Does 
this  seem  to  you  probable  ? 

13.  "Trade  follows  the  bank  even  more  zealously  than  the  flag." 
Do  you  agree  ? 

14.  Is  there  any  limit  to  the  amoimt  of  trade  that  can  be  developed  ? 
Do  you  mean  by  "trade"  exports  only,  or  both  exports  and 
imports  ? 

REFERENCES  FOR  FURTHER  READING 

Agger,  Eugene  K :  Organized  Banking,  chap.  vii. 

Escher,  Franklin:  Elements  of  Foreign  Exchange,  chap.  ix. 

Holdsworth,  John  Thorn:  Money  and  Banking,  chap.  xv. 

Whitaker,  Albert  C. :  Foreign  Exchange,  chap.  vii. 

Willis,  H.  Parker:  American  Banking,  chap,  vii  and  pp.  292-94. 


CHAPTER  XXI 

COMMERCIAL  PAPER  HOUSES  AND 
DISCOUNT  COMPANIES 

While  the  chart  on  page  136  indicates  that  working  capital 
is  typically  loaned  directly  by  commercial  banks  to  their  cus- 
tomers, it  also  shows  that  such  credit  is  often  extended  indirectly 
—through  the  intermediation  of  commercial  paper  houses  and 
discount  or  commercial 'credit  companies.  It  is  the  purpose  of 
the  present  chapter  to  reveal  the  nature  and  the  economic 
significance  of  the  services  that  are  rendered  by  these  recently 
developed  financial  institutions. 

The  commercial  paper  house  is  an  outgrowth  of  the  note 
brokerage  business  that  existed  in  this  country  in  the  early 
years  of  the  nineteenth  century.  It  was  not  until  weU  after 
the  Civil  War,  however,  that  the  modern  phase  of  the  business 
developed — the  phase,  that  is,  that  distinguishes  the  work  of 
the  commercial  paper  house  from  pure  brokerage;  and  its 
greatest  growth  has  come  only  during  the  last  fifteen  or  twenty 
years.  The  discount  companies  are  of  even  more  recent 
development.  While  some  of  them  purchase  accounts  receiv- 
able from  many  different  types  of  business,  these  companies, 
as  we  shall  see,  owe  their  most  significant  development  to  the 
automobile  industry  and  the  exigencies  with  which  its  financing 
has  been  confronted. 

A.  Commercial  Paper  Houses 
The  early  business  of  note  brokerage  arose  in  response 
to  a  very  definite  economic  need.  It  was  often  found  by  the 
business  men  of  a  given  locahty  that  at  times  it  was  impossible 
for  them  to  secure  from  local  banks  all  the  funds  which  they 
required;  and  at  certain  seasons  it  was  accordingly  necessary 
to  seek  banking  accommodation  in  other  centers.  And  since 
it  was  not  always  possible,  or  at  least  convenient,  for  the 

427 


438  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

borrower  personally  to  arrange  for  loans  at  a  distance,  certain 
individuals  seized  the  opportunity  of  obtaining  commissions 
by  acting  as  brokers  in  effecting  the  sale  of  notes  and  bills  of 
exchange  owned  by  merchants  and  traders.  It  should  be 
understood  that  the  note  broker  did  not  advance  the  funds  to 
the  borrower:  he  merely  undertook  to  sell  the  customer's 
paper  in  return  for  a  commission;  and  in  case  no  sale  was 
effected  the  paper  was  returned  to  the  borrower.  It  goes 
without  saying  that  in  order  to  effect  a  sale  the  broker  usually 
undertook  to  convince  the  lending  banker  that  the  borrower 
was  a  man  of  high  character  and  ability.  It  must  be  borne 
in  mind,  however,  that  the  broker  iri  no  sense  guaranteed 
the  paper;  his  service  was  merely  that  of  intermediary  between 
borrower  and  lender. 

With  the  rapid  development  of  the  country  following  the 
Civil  War  and  the  increasing  volume  of  intersectional  borrowing 
that  attended  the  ever-widening  scale  of  our  economic  and 
financial  structure,  the  note  brokerage  business  was  gradually 
superseded  by  the  work  of  the  commercial  paper  house — an 
institution  that  has  aptly  been  called  a  quasi-banking  estab- 
lishment. 

I.    PRACTICAL  OPERATIONS 

The  commercial  paper  house  acts  as  a  broker  in  that  it  brings 
buyer  and  seller — that  is,  lending  bank  and  borrowing  customer 
— together,  and  receives  a  commission,  regularly  one-quarter 
of  I  per  cent  of  the  face  value  of  the  note;  but  it  is  more  than 
a  broker  in  that  it  advances  the  funds  to  the  borrower  and 
runs  the  risk  of  having  to  hold  the  paper  imtil  maturity.  Where 
the  note  broker  merely  said  to  the  borrower,  "I  will  sell  your 
note  to  a  bank  if  I  can  and  charge  you  a  commission  for  the 
service,"  the  commercial  paper  house  says,  "We  will  advance 
you  the  funds  on  your  note  and  then  dispose  of  the  note  to  a 
banker  if  we  can;  but  if  we  cannot  dispose  of  the  paper  we 
will  carry  the  loan  until  maturity. " 

It  should  be  understood  that  the  commercial  paper  house 
never  desires  to  hold  the  paper  to  maturity,  that  it  seeks  to 


COMM'  RCIAL  PAPER  AND  DISCOUNT  COMPANIES    429 

make  its  profits  out  of  the  commissions  which  it  receives  as 
middleman.  And  since  its  chance  of  large  profits  lies  in  obtain- 
ing commissions  on  a  very  large  volume  of  sales,  it  will  be 
seen  that  carrying  paper  serves  to  reduce  the  profits  that  can 
be  made.  In  fact,  moreover,  the  cases  where  the  commercial 
paper  house  does  hold  the  paper  until  maturity  are  relatively 
few.  It  should  be  observed,  however,  that  in  all  cases  the 
commercial  paper  house  may  have  to  make  a  temporary  advance 
of  funds,  during  the  interval  of  time  between  the  purchase  of 
the  paper  from  the  borrower  and  the  sale  of  it  to  a  commercial 
bank.  This  interval  is  normally  very  brief,  for  the  marketing 
mechanism  has  been  developed  to  a  point  where  most  paper 
can  ordinarily  be  very  quickly  marketed. 

The  commercial  paper  house  requires  relatively  small  financial 
resources.  The  fact  that  the  commercial  paper  house  buys 
the  paper  outright  and  agrees  to  hold  it  to  maturity  in  case 
it  is  not  marketed  suggests  that  the  commercial  paper  house 
must  have  large  resources  of  its  own.  The  truth  is  that  the 
capital  employed  by  commercial  paper  houses,  as  in  the  case 
of  the  investment  banks,  is  relatively  small  in  proportion  to 
the  volume  of  business  conducted — for  the  reason  that  they 
are  in  a  position  to  borrow  heavily  from  the  commercial  banks. 
In  case  a  house  has  on  hand  paper  that  the  market  will  not 
absorb,  it  can  borrow  the  funds  necessary  to  hold  the  paper 
until  maturity,  by  using  the  notes  of  customers  as  collateral 
for  a  loan.  At  all  times,  indeed,  the  commercial  paper  house 
usually  borrows  a  very  large  percentage  of  the  funds  required 
to  finance  its  temporary  holdings  of  paper. 

Suppose  during  its  active  season  a  house  has  on  hand  a 
daily  average  of  $1,000,000  worth  of  paper.  On  the  basis  of 
its  own  promissory  note,  secured  by  customers'  notes  as  col- 
lateral, it  could  borrow  from  eight  to  nine  hundred  thousand 
dollars  from  the  commercial  banks.  As  the  notes  which  are 
deposited  as  collateral  are  sold,  either  the  volume  of  loans  from 
the  banks  will  have  to  be  reduced  or  else  other  notes  (newly 
acquired)  will  have  to  be  substituted  for  those  withdrawn  from 
the  banks.    Through  its  ability  to  acquire  funds  for  the  purchase 


430  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

of  additional  paper  by  pledging  the  notes  of  its  customers 
as  collateral,  a  house  may  pyramid  its  resources  many  times 
and  thus  receive  commissions  on  a  tremendous  volume  of 
business.  Some  houses,  indeed,  handle  several  hundred  million 
dollars'  worth  of  paper  annually.  The  capital  of  the  commercial 
paper  house,  it  will  be  observed,  is  thus  mainly  employed  as  a 
basis  for  credit  with  the  banks  from  which  it  borrows. 

We  have  said  that  the  commercial  paper  house  seeks  to 
derive  its  profits  from  brokerage  commissions  rather  than  in 
the  form  of  interest  on  loans.  It  will  be  noted,  however,  that 
interest  is  received  on  all  paper  during  the  time  it  is  in  the 
possession  of  the  commercial  paper  house.  The  profits  derived 
in  this  connection  may  be  said  to  represent  the  difference 
between  the  rate  which  the  paper  bears  and  the  rate  at  which 
the  commercial  paper  house  borrows  the  required  funds  from 
the  banks.  Since  the  commercial  paper  house  is  a  very  high- 
grade  risk,  owing  to  the  fact  that  it  is  a  responsible  financial 
institution  and  offers  excellent  collateral  besides,  the  rate  at 
which  it  can  procure  funds  is  t)^ically  a  little  lower  than  that 
of  an  ordinary  borrower  on  unsecured  paper. 

The  commercial  paper  house  may,  however,  "sometimes  make 
a  profit  and  sometimes  sustain  a  loss,  owing  to  a  difference 
between  the  rate  at  which  it  discounts  the  borrower's  note 
and  the  rate  at  which  it  disposes  of  the  paper  to  banks.  In  an 
ordinarily  steady  market  there  is  seldom  any  difference  between 
these  rates,  but  during  periods  of  rapidly  changing  financial 
conditions,  there  may  be  an  appreciable  margin.  When  there 
is  a  precipitate  fall  in  money  rates,  the  commercial  paper 
house  finds  its  commission,  in  effect,  supplemented;  but  when 
there  is  a  sudden  rise  in  interest  rates  it  may  find  that  the  loss 
sustained  is  more  than  enough  to  cancel  the  amount  of  the 
commission. 

The  commercial  paper  house  carefully  analyzes  credit  risks. 
Since  the  commercial  paper  house  is  a  lender  of  funds,  pending 
the  sale  of  the  paper  to  the  banks,  and  since  it  risks  its  own 
resources  in  making  such  advances,  it  is  obviously  incumbent 
upon  it  to  make  a  careful  investigation  both  of  the  conditions 


COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES    431 

of  the  money  market  in  general  and  of  the  credit  standing  of 
each  particular  borrower. 

The  broker  must  exercise  great  prudence  and  foresight  in  making 
his  loans.  He  must  follow  closely  the  trend  of  the  times,  be  possessed 
of  a  good  knowledge  of  business  conditions  in  general,  understand 
and  anticipate  the  effects  of  larger  seasonal  demands  for  money,  such 
as  attend  the  moving  of  the  crops  in  the  fall;  he  must  study  the 
possible  results  of  pending  legislation  and  international  entangle- 
ments, and  be  prepared  for  a  multitude  of  other  situations  that 
might  affect  the  status  of  money  and  credit  in  the  country.' 

Since  the  paper  dealt  in  by  commercial  paper  houses  is 
largely  single-name,  it  is  necessary  for  them  to  make  a  careful 
analysis  of  the  business  integrity  and  of  the  financial  position 
of  the  borrower,  as  recorded  by  a  balance  sheet  or  financial 
statement.  The  better  houses  have,  in  fact,  developed  elaborate 
credit  departments,  which  are  equipped  to  analyze  credits  with 
an  efficiency  equal  to  that  of  the  credit  departments  of  the 
large  commercial  banks.  While  commercial  paper  houses 
analyze  the  credit  standing  of  borrowers  before  pmrchasing  their 
paper,  it  is  important  to  note  that  they  do  not  guarantee  the 
paper — they  merely  warrant  that  it  is  legally  executed  and  that 
it  is  the.  genuine  promise  to  pay  of  an  actual  person  or  corpora- 
tion. The  banker  buys  the  paper,  not  on  the  strength  of  the 
commercial  paper  house's  indorsement,  but  on  the  strength  of 
the  borrower's  own  financial  standing.  Indeed,  the  commercial 
paper  house  does  not  indorse  the  paper  which  it  handles.  A 
note  is  made  out  "pay  to  the  order  of  ourselves,"  rather  than  to 
the  order  of  the  commercial  paper  house;  and  is  then  indorsed  in 
blank  by  the  makers.  It  is  accordingly  unnecessary  for  the 
commercial  paper  house  to  attach  its  name  to  the  doctmient, 
for  the  title  is  transferable  by  mere  delivery. 

In  lending  funds  through  the  purchase  of  commercial 
paper,  the  bank  must  either  rely  upon  the  analysis  that  has 
been  made  by  the  commercial  paper  house  or  make  an  inde- 
pendent credit  investigation  of  its  own.  It  will  be  seen  that, 
since  the  commercial  paper  house  has  risked-  its  own  funds, 

'  From  an  address  by  Walter  McAvoy  delivered  before  the  Mississippi 
Bankers'  Association,  March  12,  1918. 


432  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

a  banker  might  well  assume  that  the  commercial  paper  house 
has  made  a  reasonably  careful  investigation.  And  the  com- 
mercial paper  house  does  in  fact  recommend  its  paper  in  much 
the  same  manner  that  the  investment  banking  institution 
recommends,  but  does  not  guarantee,  the  bonds  which  it 
handles.  In  the  case  of  the  larger  banks,  however,  an  inde- 
pendent investigation  is  usually  conducted,  the  paper  being 
bought  on  a  ten-day  option,  thus  giving  the  bank  an  opporttmity 
to  make  its  own  investigation.  If  after  investigation  the  bank 
does  not  wish  to  carry  the  paper,  it  is  returned  to  the  commercial 
paper  house,  which  then  seeks  another  buyer. 

Small  country  banks,  with  inadequate  facilities  for  credit 
investigation,  particularly  at  long  range,  find  it  practically 
impossible  to  make  an  independent  investigation.  Accordingly, 
they  rely  either  upon  the  recommendation  of  the  commercial 
paper  house  or  upon  that  6f  a  large  correspondent  bank  which 
has  had  dealings  with  the  concern  whose  paper  is  being  offered 
for  sale.  A  very  great  amount  of  paper  is  now,  in  fact,  annually 
sold  by  the  commercial  paper  houses  to  banks  which  piurchase 
the  paper  merely  on  the  recommendation  of  the  commercial 
paper  houses.  The  credit  analysts  in  these  houses  therefore 
play  an  important  part  in  directing  the  flow  of  funds,  and  thus 
of  labor  and  capital,  between  the  different  divisions  of  industry 
and  the  different  individual  establishments  in  any  given  line 
of  enterprise. 

It  is  of  interest  to  note,  also,  that  in  recent  years  many 
commercial  paper  houses  frequently  make  loans  that  are 
secured  by  stocks  and  bonds  as  collateral.  Some  banks  prefer 
such  paper,  since  it  relieves  them  of  the  necessity  of  making 
a  careful  credit  analysis,  the  confidence  being  based  mainly 
on  the  collateral  rather  than  on  the  financial  standing  of  the 
borrowers.  Such  paper,  however,  usually  bears  a  slightly  higher 
rate  than  that  which  is  unsecured,  for  the  reason  that  the 
bank  which  holds  it  is  not  permitted  to  rediscount  it  at  a 
Federal  Reserve  bank.* 

'  For  provisions  of  the  Federal  Reserve  Act  governing  rediscounting 
see  p.  584. 


COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES    433 

The  operations  of  commercial  paper  houses  are  conducted  on  a 
national  scale.  A  large  percentage  of  the  business  of  commercial 
paper  houses  is  inter-city  in  its  nature.  A  house  in  Chicago, 
for  instance,  will  solicit  paper  from  business  concerns  all  over 
the  Middle  West  and  West;  indeed,  it  may  solicit  business 
practically  anywhere  in  the  United  States,  Many  of  the 
larger  borrowers,  however,  have  an  eastern  and  a  western 
broker,  and  it  is  then  agreed  that  the  eastern  broker  shall 
place  no  loans  west  of  Pittsburgh  and  vice  versa.'  Not  only 
is  the  paper  soUcited  over  a  wide  area,  but  purchasing  banks  are 
sought  everywhere.  Thus  a  note  of  a  borrower  in  Akron,  Ohio, 
may  be  sold  to  a  bank  in  Minneapolis;  and  paper  of  a  cor- 
poration in  New  Orleans  may  find  lodgment  with  a  banker  in 
Pittsburgh. 

Commercial  paper  houses,  however,  also  act  as  intermedi- 
aries between  borrowers  and  banks  within  the  same  city.  In 
Chicago,  for  instance,  the  paper  of  the  packing  houses  is  sold  to 
a  large  number  of  Chicago  banks,  both  to  the  larger  institutions 
of  the  financial  district  proper  and  to  the  many  outlying  sub- 
urban banks.  Such  paper,  it  may  be  noted,  is  purchased  by 
banks  largely  without  independent  investigation. 

Notes  sold  through  commercial  paper  houses  usually  run 
from  four  to  six  months'  time,  the  latter  duration  being  ordi- 
narily by  far  the  more  common.  Since  the  borrower  pays  a 
commission  on  the  amount  borrowed — ^usually  one-quarter  of 
I  per  cent — it  is  to  his  interest,  where  he  has  a  continuous 
need  for  funds,  to  secure  one  loan  for  six  months  rather  than 
two  loans  for  three  months  each.  Indeed,  it  would  often  be 
to  his  interest  to  borrow  for  even  longer  periods;  but  the  banks 
prefer  not  to  tie  up  funds  at  a  given  rate  of  interest  for  a  very 
long  interval.'  Commercial  paper  notes  until  recently  were 
usually  made  out  in  five  and  ten  thousand  dollar  denominations. 
But  during  the  last  few  years  the  entrance  into  the  commercial 

*  The  Pacific  Coast  states  have  also  recently  been  set  off  by  some 
houses  as  a  separate  territory. 

'  For  a  consideration  of  the  problem  of  the  liquidity  of  bank  loans 
see  pp.  531-33,  below. 


434         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

paper  market  of  a  large  number  of  small  state  and  national 
banks,  whose  lending  power  is  restricted,  has  led  to  the  issue  of 
a  very  large  volume  of  notes  in  denominations  of  twenty-five 
hundred  dollars. 

It  remains  to  be  noted  that,  the  commercial  paper  business 
was  given  a  great  impetus  by  the  development  of  the  Federal 
Reserve  System.  As  we  shall  later  see,  the  Federal  Reserve 
law  places  great  emphasis  upon  commercial  paper — not  specifi- 
cally on  paper  handled  by  the  conmaercial  paper  houses,'  but  on 
paper  that  owes  its  origin  to  actual  commercial  operations. 
Suc'^.  paper  was  intended  to  constitute,  in  fact,  the  basis  of  all 
borrowing  operations  between  individual  banks  and  the  Federal 
Reserve  institutions.'  The  paper  handled  by  these  institutions 
was  thus  placed  in  a  preferred  class  and  given  an  exceptional 
amount  of  free  advertising.  The  growth  of  the  commercial 
paper  business  has  accordingly  been  very  rapid  in  recent  years. 

At  the  present  time  there  are  about  thirty  commercial  paper 
houses  in  the  United  States  whose  business  is  national  in  scope, 
and  about  as  many  more  smaller  concerns  which  do  mainly  a 
local  business.  The  larger  houses  have  numerous  branch 
offices,  one  New  York  house,  for  example,  having  branches  in 
Boston,  Hartford,  Philadelphia,  Pittsburgh,  Detroit,  Chicago, 
St.  Louis,  Atlanta,  New  Orleans,  Los  Angeles,  San  Francisco, 
and  Seattle.  The  total  volume  of  paper  handled  by  these 
institutions  in  the  year  1919  was  in  the  neighborhood  of 
$4,000,000,000. 

The  commercial  paper  houses  are  unregulated  institutions. 
Although  the  old  note  brokers  have  emerged  into  quasi-banking 
corporations,  they  have  never  been  subjected  to  any  restrictive 
or  guiding  legislation,  their  principles  of  operation  having  been 
developed  by  strictly  pragmatic  methods.  There  was  some 
agitation  a  few  years  ago  for  the  registration  with  a  central 
agency  of  all  the  commercial  paper  issued  by  business  concerns, 

*The  term  "commercial  paper,"  as  used  on  the  street  and  in  the 
financial  press,  means  only  paper  purchased  through  commercial  paper 
houses. 

»  See  pp.  584-86  in  Part  HI. 


COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES    435 

as  a  means  of  preventing  the  selling  of  notes  by  any  one  borrower 
through  a  large  number  of  houses  simultaneously,  and  thereby 
greatly  overextending  its  credit;  but  little  has  been  heard  of  this 
proposal  in  recent  years.  While  there  are  undoubtedly  some 
dangers  to  be  guarded  against  in  this  system  of  credit  extension, 
there  is  no  question  but  that  on  the  whole  the  commercial 
paper  business  has  been  conducted  on  a  highly  efficient  and 
conservative  basis. 

II.    THE  ECONOMIC  SIGNIFICANCE  OF  COM- 
MERCIAL PAPER  HOUSES 

The  commercial  paper  house  is  of  service  alike  to  borrowers 
and  banks.  It  is  of  service  to  borrowers  in  that  it  makes  it 
possible  for  any  business  in  good  credit  standing  to  secure  needed 
funds,  even  though  the  supply  that  can  be  furnished  by  the 
local  banks  has  been  exhausted.  In  view  of  the  marked  seasonal 
variations  in  the  demand  for  fimds,  it  is  the  rule  rather  than 
the  exception  that  at  certain  seasons  of  the  year  the  supply 
of  local  funds  is  insufficient  for  the  community's  needs.  In 
many  cases,  moreover,  a  large  borrower  is  effectively  debarred 
from  securing  from  a  local  bank  all  the  accommodation  required 
by  the  legal  provisions  of  our  banking  laws,  which  restrict,  in  the 
interest  of  a  \Ndde  diffusion  of  risks,  the  loans  that  may  be  made 
to  any  one  borrower.* 

Quite  as  important  to  the  borrower  is  the  fact  that  the  com- 
mercial paper  house  enables  him  to  secure  his  funds  in  the 
cheapest  market.  It  may  be  that  the  supply  of  available  funds 
in  a  given  community  is  merely  low — not  exhausted — or  that  the 
local  bank  itself  could  procure  funds  from  correspondent  banks 
in  other  centers.  Under  such  circumstances  the  borrower 
would  have  to  pay  very  high  rates  for  funds,  were  it  not  for  the 
ready  access  to  the  general  credit  market  which  the  commercial 
paper  house  makes  possible. 

From  the  standpoint  of  the  bank,  the  purchase  of  com- 
mercial paper  offers  an  opportimity  for  broadening  the  field 

*  See  legal  provisions,  pp.  554-55- 


436  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

of  its  operations — it  opens  up  avenues  for  the  profitable  invest- 
ment of  funds  that  are  not  needed  during  periods  of  slack 
local  demands.  It  also  relieves  the  banker  in  times  of  local 
stringency  from  the  responsibility  of  straining  unduly  his  own 
credit  resources  in  caring  for  customers'  needs. 

Not  only  does  the  purchase  of  commercial  paper  permit 
the  investment  of  a  plentiful  supply  of  "seasonal"  money  in 
other  sections;  but  it  permits  banks  whose  resources  have  be- 
come permanently  greater  than  the  needs  of  the  communities  in 
which  they  are  located  to  enlarge,  notwithstanding,  the  volume 
of  their  business.  The  normal  growth  of  many  a  bank  has 
been  more  rapid  than  that  of  the  community  in  which  it  is 
located;  and  it  is  of  the  highest  practical  importance  that  an 
outlet  for  its  surplus  earnings  should  be  available.  The  total 
volume  of  business  in  many  communities  is,  moreover,  not 
sufficient  to  absorb  all  of  the  lending  power  of  even  a  very 
small  bank;  hence  access  to  the  general  lending  market  is 
indispensable  to  the  success  of  the  institution.  This  is  particu- 
larly the  case  with  small  suburban  banks  which  find  restricted 
lending  opportunities  in  their  immediate  environs. 

Even  where  the  total  resources  of  a  given  community  are 
sufficient  to  absorb  all  of  a  bank's  available  funds,  it  is  still 
often  important  that  an  outside  source  of  lending  be  available 
as  a  means  of  more  widely  distributuig  its  risks.  Where  the 
local  industry  is  of  a  specialized  nature  or  where  the  number  of 
borrowers  is  relatively  few,  a  local  bank  cannot  secure  a  wide 
distribution  of  risks  unless  it  resorts  to  the  open  market  for  the 
purchase  of  paper.  The  wider  diffusion  of  risks  that  is  made 
possible  by  the  commercial  paper  house  thus  tends  to  lessen 
the  possibility  of  bank  failures  and  to  strengthen  the  general 
credit  structure.  There  are  many  cases  of  suburban  banks, 
particularly,  where  the  purchase  of  commercial  paper  opens 
up  an  avenue  of  investment  which  is  highly  desirable  from  the 
standpoint  of  the  bank's  ability  to  meet  its  deposits  on  demand. 

Commercial  paper  houses  act  as  distributors  of  tiie  supply 
of  liquid  capital.  From  the  viewpoint  of  the  larger  economic 
organization,  it  may  be  noted  that  the  commercial  paper  houses 


COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES    437 

are  distributors  of  capital  from  places  where  it  is  relatively 
abundant  to  places  where  it  is  relatively  scarce.  In  a  country 
of  great  geographical  area  and  of  very  diverse  economic  interests, 
there  is  frequently  a  considerable  variation  in  the  demand  for 
funds  in  different  sections.  Periods  of  tight  money  in  one 
region  may  be  periods  of  relatively  easy  money  in  others. 
As  intermediaries  between  banks  and  borrowers  in  different 
parts  of  the  country,  the  commercial  paper  houses  give  flexi- 
bility to  the  financial  system  by  quickly  moving  funds  to  the 
places  of  greatest  need.  This  not  only  tends  to  equalize 
interest  rates  throughout  the  country  but  it  facilitates  pro- 
ductive activities  in  regions  which  at  times  would  be  cramped 
for  want  of  funds;  and  in  general  it  permits  a  fuller  and  a  more 
constant  utilization  of  the  financial  resources  of  the  nation  than 
would  otherwise  be  possible. 

This  equalization  of  the  supply  of  funds  in  different  centers, 
together  with  the  fuller  utilization  of  productive  resources  that 
is  thereby  made  possible,  is  obviously  not  without  its  effect 
upon  the  cost  of  conducting  business.  It  may  therefore  be 
said  that  the  commercial  paper  house  finds  both  its  opportunity 
for  obtaining  profits  and  its  social  justification  in  the  contri- 
bution that  it  makes  to  the  eflBicient  utUization  of  financial 
and  economic  resources  in  the  production  of  wealth. 

B.     Discount  Companies 

In  recent  years  there  have  developed  a  number  of  other 
financial  institutions,  whose  work,  like  that  of  the  commercial 
paper  houses,  is  mainly  that  of  intermediary  between  borrowing 
businesses  and  lending  banks.  The  institutions  in  question 
are  variously  designated  as  discount  houses,  finance  companies, 
commercial  credit  companies,  commercial  acceptance  trusts, 
automobile  banks,  etc.  It  is  somewhat  difficult  to  describe 
the  work  of  these  companies,  for  the  reason  that  the  terminology 
commonly  employed  in  describing  their  operations  is  far  from 
uniform — and  the  principles  of  operation  themselves  not  highly 
standardized.  Moreover,  since  certain  houses  specialize  in  a 
particular  type  of  operation,  while  others  engage  in  more  than 


438  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

one  form  of  financial  enterprise,  it  is  impossible  to  state  that 
the  financial  institutions  in  question  are  always  conducted  on 
principles  thus  and  so.  There  are,  however,  at  least  two  dis- 
tinct types  of  financial  enterprise  which  may  be  differentiated: 
(i)  the  purchase  of  accounts  receivable  from  business  concerns 
— in  various  lines — which  are  in  need  of  additional  working 
capital;  and  (2)  the  financing  of  the  distribution  of  automobiles 
and  other  products  that  are  commonly  sold  on  the  instalment 
plan. 

I.    PURCHASING  ACCOUNTS  RECEIVABLE 

There  are  two  principal  reasons  why  business  concerns  on 
occasion  sell  or  assign  accounts  receivable:  (i)  to  secure  the 
necessary  funds  with  which  to  postpone  or  forestall  financial 
insolvency;  and  (2)  to  secure  additional  working  capital  with 
which  to  expand  the  volume  of  business.  The  first  practice  is 
usually  regarded  as  "illegitimate"  financing,  something  to  be 
frowned  upon  by  all  conservative  and  constructive  business 
men.  The  second — a  development  of  the  last  ten  years — is,  as 
we  shall  see,  in  a  very  different  category.  Let  us  consider  each 
in  turn. 

I.  Assigning  of  accounts  by  concerns  thai  are  financially 
involved.  Suppose  a  certain  business,  which  has  $10,000  of 
accounts  receivable,  is  in  financial  straits  and  must  have 
immediately,  say,  $5,000  in  cash.  Unable  to  borrow  on  its  own 
note,  and  having  neither  customers'  notes  nor  trade  acceptances 
available  for  discount  at  a  commercial  bank,  it  still  has  in  its 
accoimts  receivable  a  resource  which  can  be  converted  into 
cash  through  the  intermediation  of  a  discount  house.  By 
purchasing  these  accounts  at  a  substantial  discount  and  collect- 
ing them  in  full  at  maturity,  a  discount  company  can  at  once 
provide  the  necessary  financial  assistance  to  the  enterprise  in 
question  and  earn  a  profit  for  itself.  The  discount  company 
receives  the  funds  which  it  advances  partly  from  its  shareholders, 
but  more  largely  from  the  commercial  bank  from  which  it 
borrows  on  its  promissory  note,  secured  by  the  purchased 
accounts  as  collateral.    The  amount  of  the  discount  varies 


COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES     439 

somewhat,  but  in  the  nature  of  the  case  the  rates  are  very 
high,  usually  ruinously  so. 

Concerns  which  sell  accoimts  receivable  are  commonly 
viewed  with  suspicion  by  the  commercial  bankers.  It  is  argued 
that  the  high  interest  rates  at  which  such  loans  are  secured 
are  prohibitive,  and  that  the  credit  standing  of  the  concern  is 
thereby  seriously  impaired,  with  the  result  that  eventual 
bankruptcy  is  rendered  the  more  certain.  While  this  is  imde- 
niable,  generally  speaking,  there  are  doubtless  niunerous  cases 
where  enterprises,  temporarily  embarrassed,  have  thus  been 
tided  over  a  difficult  period  in  their  history. 

2.  The  sale  of  accounts  by  '^well-rated"  concerns  as  a  means  of 
increasing  v  or  king  capital.  There  has  been  developed  in  the 
last  few  years  a  new  type  of  discount  or  commercial  credit 
company — one  whose  fimction  is  to  furnish  fimds,  not  to  con- 
cerns that  are  financially  involved,  but  to  well-rated  enterprises, 
which  are  in  a  position  to  make  an  efifective  use  of  more  money 
than  they  can  secure  through  regular  banking  channels. 

In  periods  of  very  active  business,  particularly,  many 
concerns  find  that  after  they  have  utilized  the  full  lines  of 
credit  extended  them  by  the  commercial  banks  they  could  make 
a  profitable  use  of  more  funds.  Indeed,  even  before  the  maxi- 
mmn  line  of  credit  at  the  bank  has  been  utilized,  a  concern 
often  resorts  to  the  sale  of  receivables  in  order  to  keep  some 
of  its  bank  credit  available  for  an  emergency.  The  money 
borrowed  may  be  devoted  to  expanding  the  volume  of  business 
through  the  purchase  of  additional  raw  materials  or  mer- 
chandise, or  it  may  be  used  to  pay  off  trade  bills,  thereby  saving 
the  discount  that  is  offered  for  early  cash  payments.  While 
the  rates  charged  for  such  funds  are  high,  the  cost  is  usually 
less  than  the  amount  of  the  cash  discount  on  trade  bills  which 
can  thus  be  saved. 

The  character  of  the  business  concerns  which  make  use  of 
such  credit  sources  may  be  seen  from  the  fact  that  one  discount 
house  in  1918  made  77I  per  cent  of  its  $55,000,000  of  loans  to 
customers  whose  commercial  ratings  were  of  the  first  or  second 
classes.  •  Nearly  75  per  cent  of  the  customers,  moreover,  were 


44©  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

concerns  rated  above  $35,000,  some  of  them  at  more  than 
$1,000,000,  the  average  size  being  between  $50,000  and  $75,000. 
It  should  be  clearly  understood,  however,  that  while  the  con- 
cerns which  borrow  in  this  way  may  typically  be  well  rated 
and  of  fair  size,  the  resort  to  the  sale  of  accounts  receivable  as 
a  means  of  raising  funds  indicates  a  credit  condition  temporarily 
such  that  commercial  banlis  are  unwilling  to  lend  them  more/ 
Concretely,  the  concern's  ratio  of  quick  assets  to  current 
liabilities  is  as  a  rule  considerably  less  than  what  is  customarily 
insisted  upon  by  the  commercial  bankers. 

The  high-grade  credit  companies  engaged  in  such  financing 
operations  sometimes  discount  the  accounts  receivable,  but 
more  commonly  they  make  a  "service  charge"  instead.  For 
instance,  one  large  commercial  credit  company  advances  about 
80  per  cent  of  the  face  value  of  each  account  at  the  time  of 
purchase,  and  the  balance  as  it  is  collected.  It  derives  its 
profit  by  a  gross  charge  of  one-twenty-fifth  of  i  per  cent  on  the 
net  face  of  accounts  for  each  day,  or  a  little  over  i  per  cent  a 
month,  plus  $5  per  $1,000  on  the  first  $100,000  worth  of 
purchases  from  any  concern  in  any  one  year.  In  order  that 
the  customers  of  a  concern  may  not  be  disturbed,  an  arrange- 
ment is  made  whereby  the  borrower  may  do  his  own  collecting; 
thus  the  customers  need  not  know  that  their  accounts  have 
been  sold.     This  is  known  as  the  "non-notification"  plan. 

This  company  makes  a  careful  credit  investigation  both 
of  the  customers  who  owe  the  accounts  receivable  and  of  the 
seller  of  the  accounts.  It  makes  use  of  Dun's  and  Bradstreet's 
commercial  ratings,  and  will  not  buy  from  any  one  concern  the 
accounts  of  customers  having  a  poor  credit  rating  to  an  amount 
in  excess  of  20  per  cent  of  the  total  volume  of  accoimts  pur- 
chased. As  a  further  means  of  minimizing  risks  it  also  seeks 
to  have  its  accounts  from  each  borrower  as  widely  distributed 
as  possible. 

The  company  makes  a  careful  investigation  of  the  credit 
standing  of  the  seller  of  accounts,  including  an  analysis  of  his 

'  Except  of  course  in  Cftses  wberf  the  \mk  credit  line  »  being  held 
open,  as  noted  above. 


COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES     441 

financial  statement,  for  the  reason  that  in  the  last  analysis  the 
seller  of  the  accounts  is  looked  to  for  payment.  Indeed,  the  seller 
is  required  to  warrant  the  accounts,  thus  assuming  a  secondary 
or  contingent  liability.  Inquiry  is  also  made  as  to  the  use  to 
which  the  borrowed  funds  are  to  be  put;  and  the  loan  is  ordi- 
narily refused  if  the  money  is  to  be  devoted  to  an  increase  in 
fixed  rather  than  working  capital.  The  discoimt  company  is 
thus  reasonably  well  protected  from  loss.  These  methods  are 
typical  of  the  largest  institutions. 

Discount  companies  borrow  heavily  from  commercial  banks. 
The  capital  and  surplus  of  these  concerns  serve  largely  as  a 
basis  for  credit  with  the  banks  from  which  they  borrow  (usually) 
on  single-name  promissory  notes  secured  by  collateral.  One 
conservative  company  with  a  capital  stock  of  $1,320,000  in 
1920  had  a  maximimi  loan  account  at  the  banks  of  $4,302,000, 
with  an  additional  $402,000  borrowed  through  a  commercial 
paper  house.  It  is  not  uncormnon,  however,  to  find  the  volume 
of  borrowed  funds  from  five  to  ten  times  the  amount  of  the 
company's  capital.  In  seeking  a  loan  the  company  always 
presents  a  financial  statement  showing  its  resources  and  lia- 
bilities. The  average  cash  balance  on  hand,  plus  the  average 
monthly  collections,  usually  exceeds  the  total  of  all  notes  payable. 
It  is  necessary  for  these  companies  to  maintain  a  high  credit 
standing  with  the  banks,  for  they  are  almost  continuously 
dependent  upon  them  for  funds. 

The  selling  of  accounts  receivable  by  a  business  concern 
in  need  of  funds  with  which  to  expand  its  business  is  usually 
justified  economically  on  the  ground  that  it  is  the  most  con- 
venient as  well  as  the  cheapest  means  of  securing  the  additional 
capital  required.  It  is  more  convenient  than  a  resort  to  the 
sale  of  additional  stock  and  at  the  same  time  it  does  not  per- 
manently increase  the  capital.  Because  of  the  necessity  of 
formulating  business  policy  with  a  view  to  long-run  conditions 
— for  periods  of  depression  as  well  as  for  times  of  great  business 
activity — this  ability  to  expand  capital  resources  by  short-time 
borrowing  rather  than  by  permanent  capital  contributions 
is  a  matter  of  genuine  ipiportance. 


442  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Does  credit  extension  by  credit  companies  restdt  in  dangerous 
business  expansion  ?  One  question  of  general  moment  may  be 
raised  here,  however.  Is  the  expansion  of  business  that  is 
thus  made  possible  economically  desirable?  Would  it  not  be 
better  if  the  verdict  of  the  commercial  bankers  were  allowed 
to  stand — the  verdict  that  the  concerns  in  question  have 
already  borrowed  as  much  as  their  financial  status  warrants? 
Does  such  credit  extension  not  lead  to  undue  or  dangerous 
expansion?  It  should  be  observed  in  this  connection  that 
while  the  commercial  banks  would  not  directly  extend  so  large 
a  volume  of  credit  to  borrowers  as  they  secure  through  the  aid 
of  these  financing  corporations,  the  funds  secured  are  neverthe- 
less largely  drawn  from  the  commercial  banks  by  an  indirect 
process.  Where  it  would  be  regarded  as  unsafe  to  make 
additional  direct  loans  to  the  borrowers  in  question,  the  inter- 
position of  a  strong  financial  intermediary  renders  the  indirect 
extension  of  such  credit  eminently  conservative.  But  safety 
to  the  loaning  banks,  immediately  speaking,  is  one  matter 
and  safety  to  the  general  business  and  credit  structure  in  the 
longer  run,  is  another.  It  may  reasonably  be  contended  that 
during  periods  of  great  business  activity  and  attending  financial 
strain  the  added  expansion  of  credit  which  these  institutions 
make  possible  only  serves  to  make  the  task  of  eventual 
credit  contraction  and  business  readjustment  the  more  difficult. 
While  this  question  cannot  advantageously  be  pursued  further 
at  this  place,  the  discussion  of  the  phenomena  of  business  cycles 
in  chapter  xxiii  below  will  throw  much  additional  light  on  the 
issue  raised. 

From  another  point  of  view,  however,  such  credit  extension 
presents  itself  in  a  much  more  favorable  light.  If  the  funds 
borrowed  are  used  to  save  the  cash  discount  offered  by  mer- 
cantile creditors,  rather  than  to  attempt  an  expansion  of  the 
total  volimie  of  business  through  the  purchase  of  additional  raw 
materials  or  stocks,  the  result  is  undoubtedly  beneficial  from 
the  point  of  view  of  the  general  credit  situation. 

Finally,  it  may  be  observed  that  these  institutions  have  thus 
far  bad  little  experience  with  the  financial  problems  incident 


COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES    443 

to  a  long  period  of  business  depression.  An  outgrowth,  in  the 
main,  of  the  financial  conditions  of  the  war  period  since  1914,' 
these  companies  to  date  have  had  nothing  but  fair  weather. 
Business  failures  have  been  almost  negUgible  and  the  oppor- 
tunities for  making  profits  quite  unprecedented.  In  'Conse- 
quence, the  risks  assumed  by  these  houses  have  been  very  small 
and  their  profits  almost  unbelievably  large.  During  a  period 
of  depression,  however,  they  will  doubtless  find  that  they  must 
greatly  reduce  the  volume  of  their  loans;  for  in  periods  of 
declining  business,  credit  lines  at  the  local  banks  are  ample  for 
all  concerns  that  are  in  a  sound  financial  condition.  As  a  means 
of  forestalling  financial  disaster,  however,  weakened  enterprises 
at  such  a  time  will,  of  course,  seek  credit  accommodation 
from  these  companies  with  renewed  vigor.  It  is  a  safe  guess 
however,  that  such  concerns  will  find  little  encouragement  from 
the  high-grade  conservative  credit  companies  which  we  axe 
here  considering. 

II.    THE  FINANCING  OF  AUTOMOBILE 
DISTRIBUTION 

The  extensive  growth  of  the  automobile  industry  during 
the  last  twenty  years  has  given  rise  to  a  very  interesting  system 
of  financing  the  distribution  of  the  product.  The  institutions 
engaged  in  this  financing  are  variously  known  as  commercial 
credit  companies,  discount  houses,  and  automobile  banks. 
Some  of  them  are  specialists  in  this  field  and  others  are  not. 
For  instance,  the  commercial  credit  company  described  above 
devotes  a  large  percentage  of  its  resources  to  the  pm-chase  of 
automobile  paper.  It  should  also  be  kept  in  mind  that  some 
houses  also  deal  in  piano,  furniture,  and  other  paper,  growing 
out  of  the  sale  of  goods  on  the  instalment  plan.  For  con- 
venience of  expression,  we  shall,  however,  here  designate  the 
institutions  in  question  as  automobile  banks. 

The  reasons  for  the  development  of  the  automobile  bank 
are   inherent  in  the  nature  of   the   distribution  end  of  the 

*Very  few  companies  were  in  existence  before  1914  and  none,appar' 
ently,  for  more  than  two  or  three  years, 


444  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

automobile  business.  The  automobile,  despite  the  current 
assertions  that  it  is  a  necessity,  has  always  been  looked  upon 
by  the  commercial  bankers  as  in  a  different  class  from  staple 
products — as  involving  relatively  large  risks.  Automobile  deal- 
ers, as  distinguished  from  the  manufacturers,  commonly  have 
relatively  small  resources;  they  buy  cars  largely  on  credit  and 
in  turn  sell  them  largely  on  credit.  It  has  been  estimated, 
indeed,  that  65  per  cent  of  the  passenger  cars  and  90  per  cent 
of  the  trucks  are  sold  on  time.  Since  the  automobile  is  ordi- 
narily in  the  nature  of  a  luxury,  it  quickly  becomes  a  drug  on 
the  market  in  a  period  of  business  depression,  and  since  second- 
hand cars  are  subject  to  very  heavy  depreciation,  commercial 
banks  have  not  been  willing  to  extend  credit  to  automobile 
dealers  in  proportion  to  their  requirements  in  periods  of  rapid 
expansion.  The  automobile  discount  company  was  developed 
to  meet  the  financial  requirements  incident  to  this  situation,  to 
enable  the  automobile  industry  to  grow  as  rapidly  as  the 
demand  for  its  products  required. 

The  work  of  the  automobile  bank  is  similar  to  that  of  the 
commercial  paper  houses  and  discount  companies  described 
above.  It  is  something  more  than  a  broker  in  that  it  advances 
the  funds  to  borrowers,  and  it  is  something  less  than  a  bank  in 
that  as  a  rule  it  promptly  shifts  to  the  regular  banks  the  burden 
of  carrying  the  loan.  While  similar  to  the  institutions  already 
described,  it  has  nevertheless  evolved  certain  distinct  financial 
methods. 

There  are  two  t3^es  of  automobile  financing  operations  to 
be  described.  First,  certain  large  credit  companies  extend 
what  may  be  called  wholesale  credit  to  automobile  dealers; 
second,  there  are  many  smaller  financing  corporations  which 
speciaHze  in  the  making  of  retail  loans  secured  by  the  instalment 
notes  of  the  ultimate  purchasers  of  the  cars.  While  some 
companies  engage  in  both  types  of  operations,  as  well  as  in  the 
purchase  of  accounts  receivable  from  other  businesses,  as 
described  in  the  section  above,  it  will  make  for  clearness  if  we 
describe  the  different  operations  as  though  the  institutions 
engaging  in  them  were  specialists. 


COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES    445 

I.     The  wholesale  plan.     The  financing  conducted   under 
the  first  plan  is  designed  to  enable  the  dealer  to  secure  the  funds 

Chattel  Mortgage 


Xisffiti  cU  Mn\  bg  fS^nt  {frramt*.  Thai. 


» Dollars  tf  )  recdved  to  (he  (iiD  M6sfec^o»  of  flw 


MoHga^or:  of. 


..KcreinoRer  called  (he  Morfgagee,  has  granted  bargained,  sold,  assigned,  h-ansferred  and  sd  over,  and  bv 
,  sell,  assign,  transfer  and  set  over,  unto  the  said  Mortgagee,  the  rdlowing  described  personal  property. 
3Ssession  of  (he  Mortgagor,  to  wit: 

-  One  Motor  vehicle  manufscfitred  by.„-„ , ,.■■■_ ..  ..  , „ ,,,..,..  ..■.,.■■, No _«.... 

Model. _ — ; List  prif^  ,.  ,     , together  with  alt  added  anA 

•ubsfitufed  parts  and  equipment  placed  upon  (he  property  during  (he  life  of  this  mortga^  whether  because  of  necessary  repairs  or  oBier- 
wise,  to  have  and  fo  hold  all  and  singular  said  personal  property  and  additions  Qierefo,  above  granted,  bargained,  and  sold  or  intended 
Id  be  granted,  bargained  and  sold  unto  the  Mortgagee. 

The  conditions  of  (ht5  mortgage  are  such.  That  whereas  the  Mortgagor  has  executed  and  delivered  unto  (he  Mortgagee  a  ccsMn 
proaus90C7  note  of  even  dale  herewith,  for  Ak  porduae  money  lor  (he  hereinbefore  described  property  in  the  •un  '^ _. 


-Dollars  ($ )  ^>  with  interesi  af  file  rale  of  6%  per 


Now  if  (he  Mortgagor  shall  well  and  truly  pay  said  promissory  note  wift  inferesf  as  hereinbefore  provided  and  shall  faitiifuHy 
keep  and  perform  all  the  conditions  hereof.  a(  the  6me  and  in  the  manner  ^>ecified  (time  being  of  (he  essence  of  this  contract).  Aen  this 
nortgOk^e  shall  be  void,  otherwise  the  same  shall  be  and  remain  in  full  force  and  effect. 

And  the   Mortgagor  hereby   declares   that   he  i: 
to  sell,  convey  end  encumber  the  same,  and  that  (he  i 


The  Morfgagor  agrees  iha(  the  said  motor  vehicle  shall  be  located  and  kept  at*  , 


1  (he  dfy  of  ..^ . State  of„ 


not  be  removed  (herefixNn  except  for  installation  of  body:  then  same  must  be  returned  fo  said  premises  within  thirty  (30)  days  fiiereafter 
and  further  aorees  not  to  rent  said  motor  vehicle  or  transfer  his  interest  therein,  and  thaf  while  said  motor  vehicle  is  in  possessicHi  of  Morl> 
gagor  it  shalTnof  be  operated  or  moved  under  its  own  power  and  shall  be  kep(  in  good  repairs,  free  of  all  liens,  charges  and  (axes. 

The  Mortgagor  further  agrees  that  if  default  be  made  in  payment  of  said  note  or  said  amount  of  money  and  interest  or  in  fl»e 
performance  of  any  of  (he  conditions  herein  contained  on  the  'pert  of  the  Mortgagor  to  be  performed  at  (he  time  and  in  the  manner 
herein  specified  or  in  case  the  Mortgagor  should  commit  any  waste  or  misuse  and  not  keep  (he  property  in  firsf  class  condition  or  should 
attempt  to  sell,  secrete,  convert  or  remove  the  property  without  the  written  consent  of  (he  Mortgagee,  or  if  the  properly  should  be  seized 
upon  mesne  or  final  process  had  against  fhe  Mortgagor,  or  if  (he  Mortgagee,  at  any  fime  before  or  after  the  maturity  of  said  promissory 
nole.  or  before  any  of  said  amount  of  money  and  interest  becomes  due.  snail  deem  if  necessary  for  fhe  more  perfc^  and  complete  security 
of  the  claim  of  the  Mortgagee,  then  the  Mortgagee  is  hcrel^  authorized,  and  empowered  to  enter  any  premises  of  the  Mortgagor,  or  other 
place  where  the  property  may  be.  and  take  possession  of  the  property,  without  notice  or  demand  and  without  legal  procedure,  said  nobce 
arid  demand  being  hcrcoy  expressly  waived,  and  immediately  sell  the  property  at  public  or  private  sale,  wifhout  notice.  The  Mortgagor 
hereby  grants  unto  (he  Mortgagee  (he  right  to  become  (he  purchaser  thereof,  ana  ou(  of  (tie  proceeds  thereof,  to  retain  and  pay  said 
note  wifh  interest  and  all  other  amounts  that  may  become  due  under  the  conditions  of  (his  mortgage  and  to  pay  the  expenses  of  said 
sale,  including  expenses  incurred  in  taking  possession  of  and  keeping  the  property,  and  fo  pay  any  and  all  liens  that  may  be  thereon 
having  priority  over  (his  mortgage,  (o  pay  charges  for  placing  (he  property  in  good  saleable  condition  and  to  render  fhe  surplus  money 
to  (he  Mortgagor.  If  is  expressly  agreed  that  if  (he  unpaid  balance  on  the  note  due  to  the  Mortgagee  together  with  the  interest  provided 
and  all  other  amounb  6)af  may  become  due  uiuler  the  conditions  of  (his  mortgage,  shall  not  be  reali^  by  said  sale,  the  Mortgagor 
shall  pay  fo  (he  Mortgagee  such  deficiency  upon  demand. 

No  waiver  of  any  of, (he  conditions  of  (his  mortgage  shall  be  deemed  to  have  been  given  \ff  Ak  Mortgagee,  unless  (he  same  be 
in  writing  and  signed  by  (he  Mortgagee,  and  (he  Mortgagor  further  agrees  thai  (his  nortgagc  contains  6ie  entire  agreemenf  entered  into 
wi(h  6te  Mortgagee. 

The  (crms  heirof  are  and  shall  be  I»nding  upon  end  for  fiic  benefit  of  flw  heirs,  executors,  administrators,  successors  and  assigns 
of  boAi  (he  Mortgagor  and  Mortgagee. 

EXCEPT  AS  HEREINTOFORE  PROVTftED.  THE  MORTGAGOR  SHAU  REMAIN  AND  CONTINUE  IN  POSSESSION 
Of  THE  PROPERTY  AND  IN  FULL  ENJOYMENT  OF  THE  SAME. 

— hand  and  Seal  fhb ...■— ..—.day  ^  .  ,    ,,  A,  D.  |Q  

-._—_—« [«"*■  ] 


with  which  to  pay  the  manufacturer  for  the  cars  without  waiting 
for  their  sale  to,  or  at  least  without  waiting  for  final  payments 
from,  customers.    In  a  sense  they  are  therefore  financing  the 


446  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

manufacturers  themselves.  The  loans  are  made  to  the  auto- 
mobile dealer,  who  gives  his  promissory  note  to  the  automobile 
bank,  together  with  chattel  mortgages  on  the  cars  in  his  pos- 
session. It  should  be  stated,  however,  that  it  is  only  in  certain 
states  that  we  find  the  chattel  mortgage.  In  some  states  a 
trust  receipt  is  used,  and  in  still  others  a  conditional  sale  agree- 
ment is  employed,  the  particular  type  being  determined  by  the 
varying  laws  of  different  states.  Specimens  of  a  chattel  mort- 
gage and  of  a  conditional  sale  agreement  will  be  found  on  pages 
445  and  447.  Both  have  the  regular  forms  for  assignment  on 
the  back. 

When  cars  are  stored  **on  the  floor"  the  chattel  mortgage 
or  other  document  covers  a  particular  car,  which  can  be  disposed 
of  only  on  terms  laid  down  in  the  agreement  with  the 
automobile  bank.  There  have  been  many  cases  of  fraud  and 
deception,  however,  in  connection  with  this  floor  plan,  chattel 
mortgages  often  being  given  on  cars  which  do  not  exist,  or 
which  are  not  owned  by  the  dealer  in  question;  and  there  have 
been  cases  of  secret  sale  of  the  car  against  which  the  mortgage 
stands.  Where  cars  are  stored  in  a  warehouse,  however,  the 
warehouse  receipt  is  turned  over  to  the  automobile  bank.  In 
such  a  case  the  bank  is  much  more  adequately  protected;  and, 
it  may  be  added,  the  loan  is  usually  more  nearly  equal  to  the 
full  value  of  the  car. 

Since  the  dealer  is  constantly  selling  cars,  it  will  be  seen 
that  the  security  commonly  passes  out  of  his  possession  during 
the  life  of  the  loan.  But  under  the  terms  of  the  agreement 
with  the  dealer,  the  claim  against  the  car  still  rests  with  the 
automobile  bank.  It  should  be  observed,  however,  that  the 
bank  does  not  look  to  the  individual  who  has  purchased  the  car 
on  the  instalment  plan  for  a  payment;  he  still  looks  to  the  dealer, 
to  whom  he  has  made  the  loan  and  whose  note  he  holds. 

It  will  be  seen  from  the  foregoing  that  the  credit  standing 
of  the  dealer  to  whom  the  loan  is  made  is  of  paramount  impor- 
tance. Accordingly,  the  automobile  bank  makes  a  careful 
investigation  of  the  dealer's  moral  and  financial  standing,  even 
requiring  him,  as  a  rule,  to  furnish  a  statement  showing  his 


Condlrional  Sale  Agreement 

(fRIGINAL 

®{}iB  Agrf  PtttPttt.  made  Il.i5  Joy  of _. 

befwecn_ „ .-„ 

(Slamp  dealer's  naine  and  address  kere) 

firal  paHy.  his  or  ib  successors,  agenfs  or  assigns  (hcreinoftcr,  collectively  called  "Seller")  and 


(Purchaser's  name  and  address  here) 

s'econd  party  (hereinafter  called  "Purchaser").  WITNESSETH: 

THAT  Seller  in  consideration  of  the  payments,  covenants,  agreements  and  conditions  herein  contained  which 
on  the  pari  of  (he  purchaser  are  to  be  made,  done  and  performed,  has  (his  day  sold  and  delivered,  but  upon  the  con- 
ditions hereinafter  recited,  (o  the  Purchaser  one _. , ,^o.^».— .. ». , 

(Make  of  car  hart} 
ModeK (hereinafter  called  (he  "Car")  for . , ,  ,    ,.  ,  ■ .  .        - 

Dollars  ($! , ; ).  paid  or  fo  be  ptud  by  (he  Purchaser  (o  (he  Seller  or  order^ . . 

, ^.. Dollars  ($ )  upon  the  execution  of  (his  agreement  and  (he  balanc<F 

__«—„....-„ , —.—Dollars  ($ - )  in  instalments  as  follows: 


$. jon -..,  19i., 

$ on . ^ ,  19- 


$ : .on ^ ,  lO.       ., 


_,  I0.„ 




,10. 

_,  19.    . 

,  19- 

_.      ,  19 

._.,  19- i 

_,  19„ 

._    _,  19._ 

on 

_,  19._ 

which  instalments  of  purchase  price  shall  bear  inferesf  at  the  rate  of  six  per  cent,  per  annum  from  date  and  are  lo . 
be  evidenced  by  promissory  notes  made  by  the  Purchaser  (o  the  order  of  (he  seller,  bearing  date  hereof  and  maturing 
on  the  due  dates  of  said  respective  instalments. 

The  Car  is  subject  only  to  manufacturer's  warranty,  if  copy  of  such  warranty  is  annexed  hereto:  and  if  not  so 
annexed.  Purchaser  buys  Car  as  it  stands,  and  no  warranty,  guaranty  or  representation  as  to  the  Car  or  any  of  its 
equipment  is  otherwise  made  or  given  by  Seller. 

THE  CONDITIONS  OF  THIS  AOREEMeNT  ARE,  that  delivery  of  the  Car  by  Seller  to.Purchaser  does 
not  pass  title  thereto,  but  both  the  Car  and  the  title  thereto  shall  not  pass  by  such  delivery  but  are  and  shall  remain 
vested  in  and  be  (he  property  of  the  Seller  and  assigns  (and  any  extension  or  assignment  of  said  notes  shall  not  waive 
(his  or  any  other  conaition  herein  contained)  until  said  notes  evidencing  said  instalments  of  parchase  pilte  are  paid 
in  full. 

Upon  any  default  in  the  payment  of  the  principal  or  interest  of  any  of  said  notes,  then  any  holder  of  any  of  the 
notes  then  unmatured  may  at  his  option  declare  all  of  said  notes  immeaiafely  due  and  payable  and  the  same  shall , 
thereupon  become  Immediately  due  and  payable.  The  Purchaser  until  said  notes  are  paid  in  full  shall  not  sell,  let. 
•assign,  encumber,  use  for  hire  or  dispose  of  the  Car  (without  written  consent  of  the  Sellei^  and  the  Purchaser  shall 
keep  and  maintain  (hc  Car  in  good  order  and  repair.  Purchaser  shall  keep  the  Car  free  of  all  liens,  taxes  and  charges  and 
shall  at  his  expense  end  in  his  name  cause  the  Car  to  be  registered  and  licensed  in  compliance  with  law.  Upon  any 
default  in  payment  or  breach  of  condition  or  covenant  herein  made  by  the  Purchaser,  or  if  the  Seller  shall  deem  the 
security  for  the  payment  of  said  notes  intended  to  be  afforded  hereby  insufficient  or  unsafe,  the  Purchaser  shall  on 
demand  by  the  Seller  forthwith  deliver  the  Car  in  as  good  condition  as  when  received  by  Purchaser  upon  sale  thereof 
(ordinary  wear  and  tear  excepted)  to  Seller,  and  should  Purchaser  fail  or  refuse  upon  such  demand  to  deliver  the  Cor 
as  aforesaid  to  Seller,  the  Purchaser  agrees  that  the  Seller  shall  have  the  right  without  any  further  notice  or  demand 
forthwith  to  take  possession  of  the  Car,  wherever  found,  and  for  such  purpose  Purchaser  hereby  licenses  and  authorizes 
Seller  to  enter  any  premises  of  the  Purchaser  with  or  without  force  or  process  of  law.  and  forthwith  take  possession 
of  the  Car;  if  Seller  shall  so  take  possession  of  the  Car  by  reason. of  any  defaujt  or  breach  hereof  or  with  respect  to 
said  notes  by  Purchaser,  Purchaser  agrees  that  all  payments  made  by  Purchaser  with  respect  lo  the  indebtedness 
represented  by  said  notes  shall  belong  to  and  retained  by  Seller,  as  liquidated  damages  for  the  non  fulfillment 
Of  breoch  of  performance  of  this  agreement,  for  loss  in  value  with  respect  to  the  Car,  ond  for  the  renlol  volue  thereof. 
Seller  may,  at  option,  by  collection  suit  or  otherwise,  enforce  payment  of  said  notes,  and  no-  suits,  or  legol  proceedings 
with  respect  thereto  shall,  however,  be  deemed  any  waiver  of  soid  right  of  Seller  to  toke  possession  on  default  or  breach 
as  aforesaid.  Upon  the  Seller  so  taking  possession  of  the  Car.  Seller  may  sell  the  Car  at  public  or  private  sale  at  any 
time*  thereafter  without  any  notice  to  the  Purchoser,  and  if  upon  such  sate  the  proceeds  (hereof  are  insufficient  to  pay 
the  sums  remaining  unpaid  with  resped  to  said  notes,  and  (he  expense  caused  by  such  repossession,  removal,  reparation, 
storoge,  liens  and  sate,  ony  defidency  shall  be  paid  by,  and  any  overplus  shall  be  paid  (o  the  Purchaser.  Purchaser 
acknowledgesu  receipt  from  Seller  of  a  true  copy  of  this  ogreement. 

In  witness  whereof.  Seller  and  Purchaser,  parfies  hereto,  have  hereunto  subscribed  their  signahjres  and 
«et  their  seals  hereto  in  duplicate  on  the  day  and  year  brst  above  written. 

Witnesses: 

.        « «.. c  „ (Dealer)'  

by-. , -- - 

.  ij... ,  ,1.    _„^„  „-,..,.  ..., .—^ [Si'AiJ 

(Pvcla.tr> 


448  THE  nNANCIAL  ORGANIZATION  OF  SOCIETY 

financial  condition.  While  each  particular  loan  is  in  fact 
secured  by  a  chattel  mortgage  on  a  particular  car,  the  main  reli- 
ance is  nevertheless  placed  upon  the  dealer's  general  responsi- 
bility. Loans  made  to  dealers  in  this  way  commonly  run  for 
two  or  three  months.  "WTiile  the  loans  are  made  to  the  dealer, 
it  should  be  added,  however,  that  where  cars  are  held  in  storage, 
it  is  customary  for  the  manufacturer  to  guarantee  the  payment 
of  the  loan.  Thus  the  automobile  bank  often  has  two-name 
paper.* 

Such  companies  derive  their  profits  from  a  gross  "service 
charge"  similar  to  that  described  above  in  connection  with  the 
purchase  of  accounts  receivable.  This  charge  covers  interest 
and  profits  and  also  insurance  against  theft  and  fire.  The 
company  will  not  make  a  loan  on  an  uninsured  car;  and  by 
acting  as  agent  for  an  insurance  company,  it  obtains  a  large 
commission  on  all  insurance  that  is  written.  The  "service 
charge"  varies  somewhat,  but  is  always  high  enough  to  insure 
a  very  handsome  return  to  the  company. 

2.  The  retail  plan.  A  concrete  illustration  of  the  practice 
followed  by  a  particular  company  will  indicate  the  difference 
between  the  retail  method  of  financing  and  that  which  we 
have  just  described.  Let  us  assume  that  a  dealer  has  sold 
a  car  valued  at  $6,000  and  has  received  $1,000  down  and  for 
the  remainder  instalment  notes  of  $500  each,  payable  monthly.' 
A  chattel  mortgage  is  also  given  by  the  purchaser.  The 
dealer  borrows  $4,000  from  the  automobile  banker,  putting 
up  the  $5,000  in  instalment  notes  as  collateral  security.  The 
dealer  usually  guarantees  the  payment  of  such  notes.  The 
bank  loan  is  typically,  as  in  this  case,  80  per  cent  of  the  value 
of  the  notes  offered  as  collateral  security.  Since  the  purchaser's 
notes  are  paid  in  monthly  instalments  and  the  dealer  is  required 
to  pay  his  loan  to  the  automobile  bank  in  monthly  instalments, 
it  will  be  seen  that  the  margin  of  security  possessed  by  the 
automobile  banker  gradually  increases. 

» The  manufacturers,  however,  practically  never  guarantee  the  pay- 
ment of  retail  loans.     There  is  apparently  but  a  single  exception  to  this  rule. 
•Tlie  average  duration  of  such  credit  extension  is  about  eight  months. 


COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES    449 

It  is  the  common  practice  with  these  smaller  companies  to 
discount  the  dealer's  notes,  usually  at  5  per  cent.  And  since 
the  notes  usually  bear  interest  at  7  or  8  per  cent,  the  company 
always  secures  5  per  cent  on  the  face  of  the  note  plus,  say, 
7  per  cent  interest  on  that  portion  of  the  loan  which  it  finances 
out  of  its  own  resources.  Moreover,  since  the  company  can 
usually  borrow  from  the  commercial  bank  on  its  own  note, 
secured  by  the  instalment  notes  received  from  dealers  as  col- 
lateral, at  a  rate  lower  than  that  which  the  notes  themselves 
bear,  it  will  be  seen  that  some  additional  profit  is  thus  procured. 
It  will  be  apparent,  however,  that  it  is  the  5  per  cent  discount 
that  constitutes  the  main  source  of  income. 

The  extent  of  the  gross  profits  that  may  be  obtained  there- 
fore depends  largely  upon  the  volmne  of  loans  that  can  be  made. 
Since  the  dealer  is  required  to  pay  his  loan  to  the  automobile 
bank  in  monthly  instalments,  this  bank  is  in  fact  in  a  position 
at  the  end  of  each  month  to  make  a  new  loan  of  several  thousand 
dollars  on  the  basis  of  the  instalment  receipts,  borrowing  as 
before  80  per  cent  of  the  amount  from  a  commercial  bank,  on 
the  collateral  security  of  a  new  dealer's  note  and  chattel  mort- 
gage. These  monthly  payments,  it  will  be  observed,  will  prove 
cumulative  as  additional  loans  are  extended,  each  of  which 
calls  for  monthly  payments.  In  fact,  by  virtue  of  its  abiUty  to 
borrow  from  the  commercial  banks,  a  company  is  in  a  position 
rapidly  to  pyramid  the  volume  of  its  business.  It  is  commonly 
believed  that  loans  may  safely  be  made  to  eight  or  ten  times 
the  amount  of  the  company's  capital. 

The  profits  of  such  companies  have,  in  fact,  often  been  very 
large,  though  the  earnings  fluctuate  widely,  varying  with 
changing  conditions  in  the  automobile  industry.  It  may  be 
noted  that  the  clerical  force  required  to  run  such  an  institution 
is  very  small.  There  is  usually  only  a  manager,  an  assistant 
manager,  a  bookkeeper,  and  a  stenographer,  with  one  or  more 
salesmen. 

These  companies  have  also,  to  some  extent,  financed  auto 
trucks  and  tra^ctors.  But  the  hazards  here  have  been  foimd 
considerably  greater  than  in  the  case  of  passenger  cars.    This  is 


4SO  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

particularly  true  of  tractors,  which  are  subject  to  a  rapid  depre- 
ciation because  of  the  farmer's  customary  failure  to  house  them 
properly  against  inclement  weather.  Trucks  are  also  subject 
to  heavy  depreciation;  and  it  appears  that  the  moral  hazard 
has  proved  somewhat  greater  with  trucks  than  with  passenger 
cars. 

The  funds  employed  by  automobile  banks  are  procured  in  a 
variety  of  ways.  Thus  far  we  have  been  placing  emphasis  upon 
the  methods  by  which  the  automobile  bankers — ^both  wholesale 
and  retail — extend  credit  to  the  automobile  industry,  only 
incidental  reference  having  been  made  to  the  sources  of  the 
funds  used  by  these  institutions.  There  are,  in  fact,  several 
different  methods  by  which  the  automobile  bankers  secure  the 
fimds  which  they  lend.  In  all  cases,  of  course,  a  part  of  it  is 
derived  from  the  capital  contributions  of  the  company's  share- 
holders; but  this  capital  is  mainly, employed  to  serve  as  the 
basis  of  the  company's  own  credit.  These  institutions  secure 
the  funds  which  they  loan,  in  four  different  ways,  some  com- 
panies using  but  a  single  method,  others  at  one  time  employing 
one  means  and  again  another,  and  some  of  them  now  and  then 
using  a  combination  of  methods  simultaneously. 

First,  they  may  borrow  from  the  commercial  banks,  or 
through  commercial  paper  houses,  on  their  single-name  prom- 
issory notes,  without  other  security.  So  far  as  the  author  is 
aware,  there  is  only  one  company  using  this  method.  Second, 
they  may  borrow  from  commercial  banks  on  their  promissory 
notes,  secured  by  the  instalment  notes  of  the  purchasers  of  cars. 
The  officers  of  the  credit  company  also  frequently  indorse  the 
notes.  Third ,  they  may  raise  the  funds  by  selling  the  company's 
unsecured  debenture  bonds  in  the  investment  market.  This 
method  is  apparently  not  very  commonly  employed.  Finally, 
they  may  secure  the  money  by  selling  in  the  investment  market 
collateral  trust  notes  or  bonds. 

The  last  method,  only,  requires  explanation.  The  com-^ 
pany  assigns  the  notes  received  from  its  customers,  together 
with  the  chattel  mortgages  or  other  documents,  to  a  trust 
company  where  they  are  held  in  trust  as  collateral  for  the  bonds 


COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES    451 

to  be  issued.  Guaranties  from  the  various  dealers  who  have 
given  notes,  to  the  effect  that  both  principal  and  interest  will  be 
promptly  paid,  are  also  turned  over  to  the  trust  company.  The 
financing  corporation  then  issues  its  own  obligations,  secured  by 
these  commercial  notes,  mortgages,  and  guaranties,  and  offers 
them  for  sale  in  the  general  investment  market.  They  are 
usually  issued  as  short-term  serial  notes,  some  of  which  mature 
every  few  months. 

The  following  statement  of  a  commercial  security  company 
which  purchases  mortgages  and  leases  on  cars  and  pianos  wDl 
serve  to  show  the  exact  nature  of  the  seciurity  possessed  by 
the  purchasers  of  the  company's  bonds. 

First:         Financial  statement  of  dealer  on  form  supplied. 

Second:  Execution  of  an  agreement  in  duplicate  on  forms  fiu:- 
nished,  covering  details  and  conditions  of  purchase  of 
mortgages  and  leases. 

Third:  Naming  of  someone  in  vendor's  employ  to  be  authorized 
to  make  collection  on  mortgages  and  leases  purchased, 
who  shall  be  bonded  by  fidelity  bond  to  make  prompt 
remittance  of  collections,  as  provided  in  agreement. 

Fourth:  Listing  of  mortgages  and  leases  offered  for  sale  on  blanks 
furnished,  duly  assigning  and  guaranteeing  mortgages 
and  leases  listed. 

Fifth:  Mortgages  and  leases  must  show  that  they  have  been 
recorded,  if  required  by  state  law,  and  recorder's  certificate 
of  filing  must  be  attached. 

Sixth:  Mortgages  and  leases  must  show  a  minimum  cash  pay- 
ment of  20  per  cent  of  purchase  price. 

Seventh:  Mortgages  and  leases  must  draw  at  least  6  per  cent 
interest  per  annum. 

Eighth:  Final  instalments  on  mortgages  and  leases  must  mature 
within  thirty-one  months  of  date  of  sale  to  the  Com- 
pany. 

Ninth:  Under  the  terms  and  agreements  to  be  entered  into, 
mortgages  and  leases  are  to  be  purchased  for  90  per  cent 
of  the  balance  due  and  owing  thereon,  payable  70  per  cent 
at  the  time  of  purchase,  and  the  balance  in  quarter-annual 
payments  of  20  per  cent  of  amounts  collected  and  remitted 
on  mortgages  and  leases,  provided  that  no  payments  on 
same  are  in  default,  in  which  case  same  will  be  held  until 
such  defaults  are  settled. 


To  Iw  ttsed  io  the  StatM  of  Kew  Jerwy.  nUnoli,  and  PenBSTtrgait, 

Lease  Agreement 

ORIGINAL 

QIIli0   Agr»ltUnt.  made  this __day  of ,  w 

between , . ■, 

(LesBor'B  name  and  addresa  here) 
first  party,  his  «r  to  successors,  agents  or  assigns  hereinafter  collectively  called  *'Lessor">  and 

(Lesaee'a  name  and  addieaa  here) 
second  party  (hereSnafter  called  Lessee^ 

WITNESSETH: 

THAT  the  Lessor  has  this  day  delivered  in  good  condition  and  hereby  leases  upon  the  terms,  rental,  and 

for  the  time  below  specified,  to  the  Lessee  one No , 

<Make  of  vehicle  here) 
Model (hereinafter  called  the  "Car")  valued  at 


Dollars  ($ )  iot  the  use  of  which  during  this  lease  the  Lessee  has  this  day  paid 

I  ., Dollars   ($^,_ . =_)   as  first  instalment  of  rental 

and  agrees  to  pay  the  Lessor  or  order  a  total  of 


Bollars  ($ — 

_>  in  further  insta 
10 

10 

10 

19 

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and  further  agrees  to  payand  reimburse  the  Lessor  with  respect  to  any  damage  to  the  Car  while  the  Car  is  in 
the  Lessee's  possession  under  this  lease,  except  such  depreciation  as  may  be  occasioned  by  ordinary  wear  and 
tear.  Said  instalments  of  rental  shall  bear  interest  at  the  rate  of  six  per  cent,  per  annum  from  date,  and  are  to  be 
evidenced  by  promissory  notes  made  by  the  Lessee  to  the  order  of  the  Lessor  bearing  date  hereof  and  maturing 
on  the  due  dates  of  said  respective  instalments.  The  term  of  this  lease  is  from  date  hereof  until  the  due  date 
of  said  final  instalment,' unless  sooner  Jetennined  subject  to  the  provisions  and  terms  hereof. 

The  Car  is  subject  only  to  manufacturer's"  warranty,  if  copy  of  such  warranty  is  annexed  hereto,  and  if  not 
so  annexed,  Lessee  leases  Car  as  it  stands  and  no  warranty,  guaranty  or  representation  as  to  the  Car  or  any  of 
its  equipment  is  otherwise  made  or  given  by  Lessor. 

IT  IS  FURTHER  AGREED  that  the  Lessee  shall  not  use  for  hire,  underlet  or  encumber  the  Car  or 
permit  the  same  to  pass  from  his  possession;  nor  shall  the  Lessee  assign  this  lease.  Upon  default  by  the  Lessee 
with  respect  to  any  rental  payments  evidenced  by  said  notes,  principal  or  interest,  then  the  holder  of  any  notes 
tiien  unmatured,  may  at  his  option  declare  all  of  said  notes  immediately  due  and  payable,  and  the  same  shall 
thereupon  become  immediately-due  and  payable.  The  Lessee  shall  keep  and  maintain  the  Car  in  good  order 
and  repair  and  free  from  all  taxes,  liens  and  charges,  and  surrender  the  same  to  the  Leftor  at  the  expiration  of 
this  lease.  Upon  any  default  in  payment  of  any  instalment  of  rental,  or  upon  breach  of  any  condition  or  coven* 
ant  herein  made  by  the  Lessee,  the  Lessee  shall  on  demand  of  the  Lessor  forthwith  deliver  the  Car  in  as  good 
condition  as  when  received  by  the  Lessee  (ordinary  weac  and  tear  excepted)  to  Lessor,  and  should  Lessee  fail 
or  refuse  upon  such  demand  to  deliver  the  Car  as  aforesaid  to  Lessor,  the  Lessee  agrees  that  the  Lessor  shall 
have  the  right  without  any  further  notice  or  demand,  to  terminate  this  lease  forthwith  and  to  take  possession 
of  the  Car,  wherever  found,  and  for  such  purpose  Lessee  hereby  licenses  and  authorizes  Lessor  to  enter  the 
premises  of  the  Lessee  with  or  without  force  or  process  of  law,  and  take  possession  of  the  Car.  Lessor  may,  at 
option,  by  collection,  suit  or  otherwise,  enforce  payment  of  said  notes,  and  no  suits  or  legal  proceedings  with 
,  respect  thereto  shall,  however,  be  deemed  any  waiver  of  said  right  of  Lessor  to  take  possession  on  default  or 
breach  as  aforesaid.    Lessee  acknowledges  receipt  from  Lessor  of  a  true  copy  of  this  agreement. 

In  wrrXESS  WBEXEor,  Lessor  and  Lessee,  parties  hereto,  have  hereunto  subscribed  their  signatures  and  set 
their  seals  hereto  in  duplicate  on  the  day  and  year  first  above  written. 

.WVnesses: 

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COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES    453 

Tenth:  Mortgages  and  leases  must  be  guaranteed  both  as  to 
principal  and  interest  by  the  dealer  or  manufacturer 
from  whom  they  are  purchased. 

The  leases  referred  to  relate  to  the  loan  of  a  car  to  the 
purchaser  during  the  period  when  it  is  being  paid  for.  On 
page  452  will  be  found  a  specimen  form. 

These  credit  companies  render  important  economic  services. 
The  nature  of  the  service  rendered  by  these  financing  corpo- 
rations in  connection  with  the  automobile  and  similar  industries 
was  suggested  in  the  introductory  paragraph  of  this  section, 
on  page  443  above.  The  process  of  marketing  automobiles, 
pianos,  etc.,  is  such  that  the  regular  financial  institutions  have 
neglected  the  financial  requirements  of  these  industries, 
particularly  in  periods  of  rapid  expansion.  Credit  companies 
have  therefore  filled  a  breach  in  the  financial  structure  and 
devised  methods  which  at  once  minimize  their  own  risks  and 
insure  the  earning  of  large  profits,  while  at  the  same  time  they 
make  it  possible  for  the  commercial  banking  institutions  and 
the  investing  public  indirectly  to  furnish  the  funds  required. 
Without  them  it  is  believed  that  the  development  of  such 
industries  would  have  been  very  seriously  impeded. 

In  the  city  of  Chicago  alone  there  are  more  than  thirty 
financing  corporations  of  the  types  which  we  have  been  consider- 
ing above,  while  in  New  York  there  is  an  even  greater  number. 
They  are,  moreover,  found  in  nearly  all  parts  of  the  country — 
wherever  the  need  for  them  has  been  manifested.  An  interest- 
ing development  in  the  last  year  or  so  has  been  the  organization 
of  auto-finance  credit  associations  in  New  York  and  Chicago. 
The  purpose  of  these  associations  is  to  exchange  information 
with  reference  to  the  credit  standing  of  borrowers;  and  to  co- 
operate in  every  way  in  raising  the  general  plane  of  the  business. 
Like  the  commercial  paper  houses,  the  discount  companies 
are  subject  to  no  special  legal  regulations,  being  governed  only 
by  the  general  laws  relating  to  ordinary  corporate  and  business 
activities.    While  their  operations  have,  as  a  rule,  not  yet  been 


454        THE  FINANCIAL  ORGANIZATION  OF  SOCIETV 

placed  upon  so  efficient  a  basis  as  those  of  the  commercial  paper 
houses,  they  are  being  rapidly  improved,  and  will  no  doubt 
eventually  assume  a  highly  standardized  form.  In  any  event 
these  institutions  have  already  achieved  a  permanent  place  in 
the  American  financial  system. 

QUESTIONS  FOR  DISCUSSION 

I,  THE  WORK  OF  COlfOfERCIAL  PAPER  HOUSES 

1.  How  does  the  work  of  the  comhiercial  paper  house  differ  from 
that  of  pure  brokerage  ?    How  does  it  differ  from  pure  banking  ? 

2.  Why  does  the  commercial  paper  house  not  wish  to  indorse  the 
notes  which  it  handles  ?  How  is  title  passed  without  indorse- 
ment? 

3.  Tell  in  your  own  words  precisely  how  the  commercial  paper  house 
makes  its  profit. 

4.  Do  you  think  a  commercial  paper  house  would  be  equipped  to 
make  as  good  a  credit  investigation  as  a  small-town  bank? 
As  a  large  metropolitan  bank  ? 

5.  If  you  were  a  small-town  banker  desiring  to  purchase  commercial 
paper  of  borrowers  in  other  cities,  would  you  be  wUling  to  trust 
the  recoEomendation  of  a  commercial  credit  house  ?  If  not,  how 
might  you  secure  the  information  which  you  desire  ? 

6.  State  the  services  that  are  rendered  by  the  commercial  paper 
house:   (o)  to  borrowers;   (6)  to  bankers. 

7.  State  in  your  own  words  the  economic  significance  of  conmiercial 
paper  houses. 

II.  THE  PURCHASE  OF  ACCOUNTS  RECEIVABLE 

8.  Do  you  agree  with  the  common  contention  that  a  concern  that 
buys  accounts  receivable  from  businesses  which  are  in  financial 
straits  is  engaged  in  "illegitimate"  financing  ? 

9.  If  you  were  managing  an  enterprise  that  was  in  financial  difl5cul- 
ties,  would  you  resort  to  the  sale  of  accounts  receivable  as  a 
means  of  relief  ? 

10.  Why  is  it  necessary  for  a  concern  which  purchases  accoimts 
receivable  from  such  a  concern  to  charge  very  high  rates  ? 

11.  State  in  your  own  words  how  the  second  type  of  institution  that 
purchases  accounts  receivable  differs  from  the  first  one  mentioned 
in  the  text. 


COMMERCIAL  PAPER  AND  DISCOUNT  COMPANIES    455 

12.  Using  the  data  given  in  the  text,  figure  what  the  gross  service 
charge  amounts  to  in  terms  of  percentage  on  the  funds  borrowed. 

13.  If  you  were  managing  an  enterprise  that  was  in  need  of  additional 
funds,  would  you  be  willing  to  pay  a  service  charge  as  large  as  is 
indicated  by  the  figures  derived  in  question  12?  Would  you  not 
prefer  to  issue  more  stock  or  sell  more  bonds  ? 

14.  Show  concretely  the  relation  of  the  commercial  banks  to  the  work 
of  companies  which  purchase  accounts  receivable. 

15.  If  you  were  a  commercial  banker  and  were  unwilling  to  extend 
credit  to  a  concern  in  the  form  of  a  direct  loan,  would  you  be 
wUling  to  extend  it  funds  indirectly,  through  the  intermediation 
of  a  discoimt  company  ? 

16.  What  is  your  conclusion  as  to  the  economic  justification  of  the 
practice  of  selling  accounts  receivable? 

m.      THE   FINANCING   OF  AUTOMOBILE  DISTRIBUTION 

17.  What  is  the  essential  difference  between  the  financing  of  retail 
distribution  and  the  financing  of  the  wholesale  end  of  the  busi- 
ness? 

18.  Are  there  any  respects  in  which  you  think  the  security  back  of 
the  loans  made  by  the  automobile  banks  is  inadequate  ? 

19.  Study  the  copies  of  the  chattel  mortgage,  conditional  sale  agree- 
ment, and  lease  agreement,  and  state  what  rights  are  granted  to 
the  lender  in  each  case. 

20.  How  do  the  larger  automobile-financing  corp)orations  make  their 
profits  ? 

21.  How.  do  the  smaller  discount  houses  which  finance  the  retail 
end  of  the  trade  make  their  profits  ?  Do  you  see  any  advantage 
in  one  method  as  compared  with  the  other  ? 

22.  If  you  were  managing  one  of  these  companies,  would  you  attempt 
to  secure  the  funds  required  by  borrowing  from  commercial 
banks  or  by  selling  either  debentures  or  collateral  trust  notes 
in  the  investment  market  ?    Why  ? 

23.  In  case  you  elected  to  borrow  from  a  commercial  bank,  what 
would  determine  whether  you  would  borrow  on  an  unsecured 
promissory  note,  or  on  the  collateral  consisting  of  customers' 
notes  ?  In  case  you  borrowed  in  the  investment  market,  what 
would  determine  whether  you  would  issue  simple  debenture 
bonds  or  collateral  trust  notes  ? 

24.  What  is  the  purpose  of  the  serial  feature  of  the  collateral  trust 
notes? 


4S6  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

25.  In  the  case  of  the  serial  notes  described  on  page  451,  do  you 
think  the  investment  would  be  reasonably  safe  ?  How  would 
you  compare  it  with  bonds  of  an  industrial  concern,  where  the 
funds  are  devoted  to  fixed  capital  purposes  ? 

26.  State  in  your  own  words  what  you  consider  the  economic  justi- 
fication of  the  automobile  and  piano  bankers.  Have  you  any 
criticisms  to  make  with  reference  to  their  operations  ? 


CHAPTER  XXII 

THE  COMMERCIAL  BANKING  SYSTEM 

The  commercial  bank  was  studied  in  chapter  xix  as  a 
special  type  of  financial  institution,  and  as  such  it  was  discussed 
in  isolation,  that  is,  independently  of  its  relations  to  other 
banks.  We  shall  find,  however,  that  commercial  banks  are 
closely  interrelated,  each  individual  institution  being  in  the 
ordinary  course  of  its  business  brought  into  contact  with 
other  banks — with  those  in  the  same  city  or  community,  with 
those  in  other  cities,  and  even  with  the  institutions  of  other 
countries.  Taken  as  a  whole,  the  commercial  banks  constitute 
what  may  be  called  a  commercial  banking  system.  In  the 
present  chapter  we  shall  consider  the  nature  of  these  inter- 
relations and  the  reasons  for  their  development,  together  with 
the  origin  and  nature  of  the  phenomenon  of  credit  currency. 

I.    CLEARING-HOUSE  ASSOCIATIONS 

The  banks  of  aU  the  important  financial  centers  of  the 
country  have  worked  out  certain  of  their  relations  through 
clearing-house  associations.  A  clearing-house  association  may 
be  defined  as  an  organization  of  banks  designed  to  promote 
in  every  possible  way  the  mutual  interests  of  the  members. 
The  most  common  of  these  mutual  services  and  the  one  that 
has  excited  by  far  the  greatest  popular  interest  is  that  of  clearing 
checks.  The  practical  operation  of  the  clearing-house  in  this 
:apacity  may  be  readily  described. 

Let  us  assume  that  in  a  given  city  there  are  twenty  banks 
which  are  members  of  the  clearing-house  association.  Each 
day  bank  No.  i  receives  from  its  depositors  a  considerable 
number  of  checks  which  have  been  drawn  against  each  of  the 
other  nineteen  banks;  and,  in  turn,  each  of  the  other  banks 
receives  checks  drawn  on  all  the  rest.    Bank  No.  i  credits 

4S7 


458  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

to  the  deposit  accounts  of  its  customers  the  checks  as  it  receives 
them;  and  it  must  then  collect  these  checks  from  the  banks 
against  which  they  have  been  drawn.  Before  the  hour  set 
for  exchanging  the  checks  at  the  clearing-house  the  clerks  in 
bank  No.  i  assemble  them  in  bundles,  so  that  all  of  those  that 
are  payable  by  each  bank  will  be  together.  The  total  amount 
of  the  checks  to  be  presented  to  each  bank  is  also  added  up  on 
a  sheet  of  paper.  At  the  hour  of  clearing,  messengers  from  the 
several  banks  appear  at  the  clearing-house  for  the  purpose  of 
securing  payment  of  the  checks.  The  process  by  which  these 
checks  are  "cleared"  is  as  follows: 

Within  the  clearing-house  is  a  large  circular  desk,  with 
twenty  compartments  or  stalls.  In  compartment  i  is  a  clerk 
representing  bank  No.  i ;  in  compartment  2,  a  clerk  representing 
bank  No.  2,  etc.  The  messenger  from  bank  No.  i  deposits  in 
compartment  2  the  checks  payable  by  bank  No.  2;  in  com- 
partment 3,  the  checks  payable  by  bank  No.  3;  and,  in  turn, 
in  each  of  the  nineteen  compartments.  In  his  turn,  the  mies- 
senger  from  bank  No.  2  deposits  in  compartment  i  the  checks 
payable  by  bank  No.  i;  in  compartment  3  those  payable  by 
bank  No.  3,  and  so  on  around  the  circle.  The  messengers 
from  banks  Nos.  3,  4,  etc.,  likewise  deposit  their  bundles  in 
the  nineteen  compartments  representing  the  nineteen  banks 
against  which  the  checks  have  been  drawn.  At  the  conclusion 
of  this  presentation  of  the  checks  to  the  proper  compartments, 
each  clerk  will  find  in  his  compartment  nineteen  bundles  of 
checks,  all  of  which  are  payable  by  his  bank.  These  checks 
are  turned  over  to  the  messengers,  who  take  them  immediately 
back  to  their  respective  banks.  Thus  the  physical  transfer 
of  the  checks  has  been  accomplished. 

Many  checks  are  traded  directly  between  banks.  It  should  be 
stated,  parenthetically,  that  as  a  means  of  relieving  the  con- 
gestion of  work  in  the  banks  in  the  larger  financial  centers  a 
considerable  percentage  of  the  checks  that  are  cleared  are  not 
actually  sent  through  the  clearing-house,  although  their  totals 
are  included  in  the  sums  which  appear  upon  the  clearing-house 
records.    The  reason  for  this  is  as  follows:  The  clearing  usually 


THE  COMMERCIAL  BANKING  SYSTEM  459 

occurs  at  10:30  a.m.;  and  after  that  hour  the  bank  continues 
to  receive  checks  from  its  customers,  so  that  by  the  end  of 
the  day  it  has  assembled  a  large  nimiber  of  checks  payable  by 
other  banks.  Again  at  the  opening  of  the  bank  the  following 
morning  a  large  number  of  checks  is  soon  received.  Now, 
if  bank  No.  i,  for  instance,  did  not  present  any  of  the  checks 
to  the  other  banks  until,  say,  eleven  o'clock,  the  end  of  the 
clearing  period,  there  would  then  be  an  enormous  rush  in 
assorting  them  and  crediting  them  to  the  proper  accounts. 
It  facilitates  matters  very  greatly  if  the  checks  accumulated 
after  the  clearing  hour  are  sent  to  the  banks  upon  which  they 
are  drawn  in  the  afternoon  of  that  day,  and  if,  say,  the  first 
hour's  collection  in  the  morning  is  sent  over  in  advance  of  the 
10:30  A.M.  clearing  hour.  Bank  No.  i  therefore  sends  its 
accmnulated  checks  drawn  on  banks  Nos.  2,  3,  etc.,  to  these 
banks  and  trades  them  for  a  "batch"  of  checks  drawn  against 
itself,  which  the  other. banks  have  received  from  their  depositors. 
Each  bank  can  thereupon  begin  at  once  the  work  of  debiting 
the  checks  to  the  proper  accounts.  By  having  the  receipt 
of  the  checks  spread  over  the  entire  day,  it  is  much  easier  to 
take  care  of  the  enormous  amount  of  routine  clerical  and  account- 
ing work  that  is  necessarily  thrust  upon  the  larger  institutions. 

The  greater  part  of  interbank  obligations  are  canceled.  It 
remains  to  note  how  the  balances  are  struck  and  paid  at  the 
clearing-house.  We  have  already  seen  that  bank  No.  i  has  a 
record  of  the  total  checks  which  it  presents  to  the  other  banks. 
It  also  receives  from  each  of  the  other  banks,  along  with  the 
checks,  a  statement  of  the  total  presented  by  each  of  the  other 
banks  against  it.  (This  includes  the  totals  of  the  checks  that 
have  been  traded  directly,  as  well  as  those  actually  brought  to 
the  clearing-house.)  Suppose  now  that  the  clerk  in  com- 
partment I  has  on  his  statement  $1,000,000,  due  from  the  other 
banks;  and  that  upon  footing  up  the  total  of  the  nineteen 
statements  deposited  in  his  compartment  he  finds  that  his 
bank  owes  to  the  other  banks  $1,200,000.  Bank  No.  i  has 
therefore  an  unfavorable  balance  with  the  rest  of  the  banks  of 
$200,000. 


46o         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Suppose  the  clerk  of  bank  No.  2,  in  turn,  finds  that  his 
balance  shows  $100,000  due  from  the  other  banks;  the  clerk 
of  bank  No.  3  finds  that  $50,000  is  due  from  the  other  banks; 
the  clerk  from  bank  No.  4  finds  that  $40,000  is  due  to  other 
banks,  etc.  After  finding  his  balance  each  clerk  presents  to  the 
clearing-house  manager  a  shp  showing  the  amount  due  to  or 
from  the  other  banks.  And  when  the  manager  receives  these 
slips  from  the  twenty  different  banks,  he  writes  the  amounts 
down  in  two  columns,  one  showing  the  sums  due  to  the 
clearing-house  and  the  other  showing  the  sums  due  from  the 
clearing-house.  Since  the  checks  presented  to  the  clearing- 
house by  all  the  banks  are  the  identical  checks  received  through 
the  clearing-house  from  all  the  banks,  these  totals  must  obviously 
balance.  The  clearing-house  manager  thus  has  a  ready  means 
of  "proving"  the  correctness  of  the  figures  presented  to  him. 

There  are  numerous  ways  of  paying  the  balances.  Various 
means  have  in  fact  been  employed  in  the  past  in  the  settlement 
of  these  accounts,  not  all  of  which  are  of  sufficient  importance 
to  require  description.  The  most  common  method  in  the 
larger  financial  centers,  prior  to  the  adoption  of  the  Federal 
Reserve  System,  was  through  the  use  of  clearing-house  certifi- 
cates. Under  this  method  each  member  of  the  clearing-house 
association  deposited  a  portion  of  its  cash  resources  with  the 
clearing-house  and  was  given  in  exchange  clearing-house  cer- 
tificates. These  certificates  were  commonly  of  large  denomi- 
nations— one,  five,  and  ten  thousand  dollars.  It  should  be 
noted  that,  so  far  as  the  bank's  balance  sheet  was  concerned, 
these  certificates  appeared  under  the  heading  of  Cash,  just 
as  do  gold  certificates,  which  are  claims  against  gold  in  the 
Treasury  Department  at  Washington. 

Now  when  bank  No.  i  owed  to  the  clearing-house  $200,000, 
as  in  the  foregoing  illustration,  it  would  turn  over  to  the 
clearing-house  manager  $200,000  in  clearing-house  certificates. 
Since  bank  No.  2  had  a  balance  of  $100,000  due  from  the 
clearing-house,  the  clearing-house  manager  would  pay  to 
bank  No.  2  $100,000  of  the  clearing-house  certificates  which  he 
had  received.    In  a  word,  the  clearing-house  manager  merely 


THE  COMMERCIAL  BANKING  SYSTEM  461 

acted  as  intermediary  in  the  transfer  of  thfese  clearing-house 
certificates  from  the  banks  which  had  unfavorable  balances 
to  the  banks  which  had  favorable  balances. 

It  will  be  seen  that  the  use  of  these  clearing-house  certifi- 
cates greatly  lessens  the  risk  of  transferring  funds.  For  if  a 
messenger  carrying  them  were  robbed,  no  loss  would  be  sus- 
tained by  the  banks,  since  the  clearing-house  certificates  are 
acceptable  only  in  the  paying  of  balances  between  banks. 

Clearing-house  balances  are  now  settled  by  book  entries  at  the 
Federal  Reserve  bank.  Since  the  establishment  of  the  Federal 
Reserve  System,  and  the  affliation  with  that  system  of  all 
the  important  state  banks  and  trust  companies  in  the  larger 
financial  centers,  the  process  of  settling  clearing-house  balances 
has  been  stUl  further  simplified.  In  Chicago,  for  instance, 
each  bank  belonging  to  the  clearing-house  association  has  funds 
on  deposit  with  the  Federal  Reserve  Bank  of  Chicago.  Accord- 
ingly, when  the  clearing  has  been  completed,  the  manager  of 
the  clearing-house  notifies  the  Federal  Reserve  Bank  that 
the  deposit  accoimt  of  bank  No.  i  should  be  decreased  by 
$200,000;  the  account  of  bank  No.  2  increased  by  $100,000; 
the  account  of  bank  No.  3  increased  by  $50,000;  the  account 
of  bank  No.  4  decreased  by  $40,000,  etc.  Thus  by  means  of 
simple  bookkeeping  entries  on  the  books  of  the  Federal  Reserve 
Bank,  each  bank  in  the  clearing-house  association  has  added 
to  or  subtracted  from  its  funds  the  amounts  necessary  to 
settle  its  account. 

The  banks  of  the  clearing-house  of  Milwaukee  are  also 
all  members  of  the  Federal  Reserve  Bank  of  Chicago.  And 
as  soon  as  the  clearings  have  been  completed  in  Milwaukee, 
the  manager  of  the  Milwaukee  clearing-house  telegraphs  to 
the  Federal  Reserve  Bank  of  Chicago  the  amounts  which 
should  be  debited  and  credited  to  the  accounts  of  the  different 
Milwaukee  banks. 

Not  all  the  banks  of  a  given  city  are  members  of  the  clearing- 
house association.  The  reason  for  this  is  that  it  would  com- 
plicate too  greatly  the  process  of  clearing  if  a  large  number  of 
institutions  were  involved.    Most  banks  which  are  not  members 


462  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

of  the  clearing-house  association,  however,  clear  through 
banks  which  are  members.  For  instance,  the  Woodlawn 
Trust  and  Savings  Bank  of  Chicago  clears  through  the  Fort 
Dearborn  National  Bank.  Every  day  all  the  checks  which 
are  received  by  the  Woodlawn  Trust  and  Savings  Bank  against 
other  banks  in  Chicago  are  sent  to  the  Fort  Dearborn  National 
Bank,  which  presents  them,  along  with  its  own  items,  at  the 
clearing-house.  Similarly,  when  other  banks  of  the  city 
receive  checks  drawn  against  the  Woodlawn  Trust  and  Savings 
Bank  they  present  them  through  the  clearings  to  the  Fort 
Dearborn  National  Bank.  If  on  a  given  day  the  Fort  Dearborn 
National  Bank  sent  $10,000  worth  of  checks  to  the  clearing- 
house for  the  Woodlawn  Trust  and  Savings  Bank,  and  received 
from  the  clearing-house  $8,000  worth  of  checks  drawn  against 
the  Woodlawn  Trust  and  Savings  Bank,  the  latter  would  have 
a  favorable  balance  with  the  Fort  Dearborn  of  $2,000,  which 
would  be  credited  to  its  deposit  account  in  that  bank.  On  the 
other  hand,  if  the  balance  of  the  Woodlawn  Trust  and  Savings 
Bank  should  be  unfavorable  to  a  hke  extent,  $2,000  would 
be  subtracted  from  the  credit  which  the  Woodlawn  Bank  has 
with  the  Fort  Dearborn. 

Suburban  banks  have  an  independent  clearing.  In  addition 
to  these  two  t)q)es  of  banks — those  that  are  members  of  the 
clearing-house  and  those  that  clear  through  members — there 
may  be  a  considerable  number  of  small  suburban  institu- 
tions in  the  larger  cities  which  still  use  the  messenger  service 
in  the  presentation  and  payment  of  checks.  In  1919  there  was 
established  in  Chicago,  however,  what  is  known  as  a  suburban 
clearance,  by  means  of  which  clearings  are  made  at  9  o'clock 
in  the  morning — before  the  regular  clearing  hours.  The 
suburban  banks  are  thus  enabled  to  effect  their  transfers  by 
the  same  process  that  obtains  in  the  regular  clearings  described 
above. 

The  clearing-house  is  a  very  efficient  business  agency.  The 
function  of  the  clearing-house  in  this  connection  is,  therefore, 
to  perform  certain  tasks  in  a  minimum  of  time  and  with 
a  minimum  of  risks.    It  is  a  mere  business  device  for  the 


THE  COMMERCIAL  BANKING  SYSTEM  463 

simplification  of  routine  clerical  work.  The  speed  with  which 
the  work  of  a  clearing-house  is  transacted  is  very  great,  and 
the  clerks  are  exceptionally  accurate  and  remarkably  rapid 
in  their  calculations.  The  actual  time  required  to  make  the 
exchanges  varies  from  about  two  to  ten  minutes;  and  only 
about  a  half-hour  elapses  from  the  opening  of  the  clearing- 
house until  the  entire  morning's  work  is  completed.  The  daily 
clearance  in  New  York  averages  in  excess  of  three  hundred 
milHon  dollars. 

The  clearing-house  makes  a  great  appeal  to  the  imagination 
of  many  people,  because  of  the  enormous  volume  of  exchanges 
that  are  so  quickly  eflFected.  In  large  measure,  however,  this 
appeal  is  merely  fanciful.  If  one  has  visions  of  enormous 
volumes  of  cold  cash — countless  millions  of  dollars — changing 
hands  with  lightning-like  celerity,  he  will  be  disappointed  in 
visiting  a  clearing-house;  for  instead  of  the  gUtter  of  gold, 
or  even  of  the  green  of  bills,  he  will  see  merely  a  number 
of  clerks  filing  in  and  out  with  inconspicuous  packages  of 
checks,  other  clerks  busily  engaged  iu  adding  colunms  of 
figures,  and  then  he  will  shortly  hear  the  clearing-house  manager 
announce  the  total  of  clearings  that  has  been  effected.  It  is  on 
the  whole  a  pretty  drab,  performance — ^much  less  exciting  than 
many  other  phenomena  of  business  organization  that  dis- 
tinguish our  capitaUstic  industrial  system. 

Clearing-house  associations  have  eliminated  certain  com- 
petitive hanking  practices.  While  the  greatest  interest  in  the 
clearing-house  association  has  always  centered  in  the  clear- 
ing of  checks,  some  of  its  most  important  functions  are  of 
another  nature.  I  refer  to  the  use  of  the  clearing-house 
association  as  a  means  of  controlling  certaia  competitive 
banking  activities,  in  the  interests  not  alone  of  larger  bank 
profits,  but  also  of  the  stability  and  soundness  of  the  commercial 
banking  system  as  a  whole. 

The  origin  of  the  New  York  clearing-house,  indeed,  appears 
to  have  been  attributable  as  much  to  a  desire  to  escape 
from  certain  competitive  evils  as  to  reduce  the  time  required 
for   exchanging    checks.     Before    the   establishment    of    the 


464  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

clearing-house  in  1853  the  difficulties  involved  in  settling  balances 
between  banks  in  the  metropolis  were  so  great  that  no  attempt 
was  made  to  effect  a  daily  settlement  of  accounts.  While 
checks  were  presented  each  day,  the  banks  by  informal  agree- 
ment settled  their  balances  only  once  a  week — every  Friday 
morning  following  the  exchange  of  checks.  The  cashier  of 
each  bank  then  drew  a  check  against  each  of  the  banks  from 
which  credit  balances  were  due  and  sent  a  messenger  to  collect 
them. 

This  weekly  settlement  made  it  possible  for  any  bank 
which  so  desired  to  take  advantage  of  the  others.  For  instance, 
on  Monday  bank  A  might  make  a  large  number  of  loans, 
against  which  the  borrowers  would  draw  checks.  These 
checks,  in  the  main,  would  be  presented  at  other  banks;  and 
since  these  banks  had  to  wait  until  Friday  before  they  could 
collect  from  bank  A,  it  was  possible  for  bank  A  greatly  to 
expand  the  volume  of  its  loans  at  the  expense  of  the  other 
institutions.  A  settlement  would  of  course  have  to  be  made  on 
Friday;  and  in  order  to  have  the  necessary  funds  with  which 
to  meet  its  adverse  balances,  bank  A  would  borrow  on  Thursday 
the  money  with  which  to  make  its  Friday  settlements.  When 
these  loans  were  paid  on  Saturday,  the  bank  would  again  be 
in  debt  to  all  the  others,  and  by  repeating  the  practice  of 
making  large  loans  it  would  again  secure  the  use  of  the  other 
banks'  funds. 

As  a  means  of  preventing  certain  speculative  institutions 
from  indulging  unrestrainedly  in  this  practice,  it  became 
necessary  to  agree  that  any  bank  could  "draw  against  its  credit 
balance  with  another  at  any  time  without  waiting  for  the 
settlement  on  Friday.  And  when  any  bank  was  in  need  of 
specie,  this  privilege  was  commonly  utilized.  An  old  bank 
officer  of  New  York  who  had  experience  with  these  practices 
has  stated  that  so  far  did  many  banks  expand  their  loans  that 
"a  single  small  draft  by  one  bank  on  another  would  induce  a 
general  drawing  involving  them  all  in  confusion  and  virtual 
war  on  each  other.  Three  o'clock  would  arrive  with  a  line  of 
drafts  incompleted,  thus  frequently  enabling  the  debtor  banks 


THE  COMMERCIAL  BANKING  SYSTEM  465 

to  add  $50,000  to  their  specie  holdings.  *"  The  losses  sustained 
by  the  unfortunate  banks,  together  with  the  perpetual  annoy- 
ance and  the  bitterness  of  feeling  that  was  often  engendered  by 
these  sharp  competitive  practices,  must  have  been  quite  as 
responsible  for  the  organization  of  a  clearing-house  association 
as  the  prevalent  costly  and  cumbersome  method  of  settUng 
balances. 

Once  estabUshed,  the  clearing-house  associations  became 
the  agencies  for  the  elimination  of  competitive  evils  and  the 
strengthening  of  commercial  banking  practice  in  numerous 
connections.  James  G.  Cannon,  the  authority  on  clearing- 
house practices,  says:  "The  tendency  has  been  marked, 
especially  in  recent  years,  to  include  within  the  legitimate 
field  of  clearing-houses  all  questions  affecting  the  mutual 
welfare  of  the  banks  and  the  community  as  a  whole."  The 
most  important  of  the  special  functions  designed  to  raise  the 
plane  of  banking  operations  are  as  follows:  (i)  fixing  uniform 
rates  of  interest  on  deposits;  (2)  fixing  uniform  rates  of  exchange 
and  charges  on  collections;  (3)  conducting  clearing-house 
bank  examination;  (4)  effecting  mutual  co-operation  among 
banks  in  time  of  acute  financial  strain. 

I.  Fixing  uniform  rates  of  interest  on  deposits.  Like  the 
savings  banks,  commercial  banks  have  sought  to  expand  the 
volume  of  their  resources  available  for  lending  purposes  by 
attracting  deposits  through  the  offer  of  interest  on  commercial 
accounts.  The  necessity  of  paying  deposits  on  demand  was 
of  course  recognized;  but  where  an  average  balance  above  a 
certain  minimum  was  kept  by  any  individual,  it  was  recognized 
that  interest  could  be  paid  on  such  portion  of  the  funds  as  was 
left  more  or  less  continuously  with  the  bank.  As  a  means  of 
attracting  as  large  a  volume  of  deposits  as  possible,  some 
banks  offered  rates  of  interest  that  were  higher  than  usual, 
thereby  endangering  their  solvency. 

It  is  of  course  possible  that  a  bank  might  succeed  in  pa)dng 
higher  interest  rates  on  deposits  than  the  going  rate,  if  by 
this  means  it  secured  a  substantial  increase  in  its  volume  of 

*  See  James  G.  Cannon,  Clearing  Houses,  p.  150. 


466  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

business.  But  where  competition  is  keen  the  raising  of  interest 
rates  by  one  bank  usually  forces  the  others  to  follow  suit; 
and  when  all  banks  pay  higher  interest  rates  on  deposits,  they 
merely  lessen  the  margin  of  banking  proj&ts  that  can  be  obtained 
and  imperil  in  no  small  degree  their  own  financial  secmity. 

It  gradually  became  apparent  that  in  the  interest  of  sound 
banking  the  raising  of  rates  on  deposits  as  a  means  of  attracting 
business  was  detrimental  to  the  banks  as  a  whole  and  thus  to 
business  in  general.  The  clearing-house  associations  provided 
a  means  whereby,  through  concerted  action,  the  associated 
banks  could  agree  to  regulate  such  competitive  practices. 
Rates  of  interest  were  agreed  upon  as  early  as  1881  in  Buffalo; 
and  other  associations  have  gradually  fallen  into  line.  While 
the  agreements  differ  somewhat  in  different  cities,  2  per  cent 
per  annum  has  in  recent  years  been  the  usual  rate  on  deposit 
balances  above  a  certain  minimum,  commonly  $1,000.  This 
applies  both  to  bankers'  balances  and  to  the  deposits  of  indi- 
viduals.' 

The  legality  of  agreements  of  this  sort  has  of  course  been 
questioned  and  some  associations  still  regard  it  as  a  moot 
practice,  and  are  hence  reluctant  to  estabUsh  and  enforce  any 
particular  rate.  Even  in  these  cases,  however,  there  seems 
to  be  more  or  less  tacit  assent  to  uniform  rates. 

The  fixing  of  interest  rates  on  loans  has  also  been  considered 
by  many  clearing-home  associations.  But  in  most  instances 
the  suggestion  has  not  met  with  favor,  for  two  reasons:  first, 
the  individual  banks  look  upon  the  loaning  of  money  as  their 
most  distinctive  prerogative  and  would  regard  agreements 
upon  the  rates  at  which  money  should  be  loaned  as  a  virtual 
elimination  of  all  individual  initiative  in  bank  management; 
second,  such  agreements — ^whatever  the  rates  determined 
upon — would  doubtless  smack  of  monopoly  control  and  invite 
restrictive  legislation. 

It  is  an  interesting  observation  that  there  is  much  more 
likely  to  be  agreement  on  interest  rates  in  country  towns  and 

» During  the  Great  War  the  rate  was  raised  to  2^  per  cent,  at  least  ia 
some  centers. 


THE  COMMERCIAL  BANKING  SYSTEM  467 

villages  than  in  the  large  financial  centers.  There  appear  to  be 
many  cases  where  there  are  informal  agreements  between 
banks  in  small  towns  that  money  shall  not  be  loaned  for  less 
than  6,  8,  or  10  per  cent,  as  the  case  may  be.  In  the  larger 
cities,  however,  there  is  undoubted  independence  in  this  matter, 
although  in  the  nature  of  things  there  is  seldom  any  wide 
disparity  in  rates,  owing  to  the  very  close  competition  that 
obtains  and  to  the  equalizing  effect  of  the  operations  of  the 
commercial  paper  houses.  Since  the  establishment  of  the 
Federal  Reserve  System,  moreover,  the  rates  of  rediscount  at 
the  Federal  Reserve  banks  exercise  a  controlling  influence.* 

2.  Fixing  uniform  rates  of  exchange  and  collection  charges. 
Everyone  dislikes  to  pay  exchange  and  collection  charges; 
and  one  of  the  best  devices  for  attracting  additional  business, 
therefore,  has  been  the  elimination,  or  the  reduction,  of  such 
charges.  Now  any  particular  bank  might  well  more  than  make 
good  the  losses  sustained  by  furnishing  drafts  to  customers 
and  collecting  items  free  of  charge,  out  of  the  enlarged  volume 
of  business  obtained  as  a  result  of  such  a  policy.  But  when 
all  the  banks  of  a  given  community,  under  the  impetus  of 
competition,  engage  in  rate  cutting,  it  is  obvious  that  the 
collection  costs  to  the  banks  as  a  whole  cannot  be  coimter- 
balanced  by  an  increased  volume  of  business  for  the  banks  as  a 
whole.  We  have  here  a  case  of  cut-throat  competition  similar 
to  that  which  for  so  long  a  period  led  to  the  financial  embar- 
rassment of  railroads  and  industrial  concerns.  The  clearing- 
house associations  again  provided  the  mechanism  for  agreements 
on  uniform  exchange  and  collection  charges;  and  again  it  was 
in  Buffalo,  in  1881,  that  the  first  agreement  was  made.  A  scale 
of  charges  was  adopted  and  put  into  successful  operation, 
the  rates  not  being  high,  but  arranged  as  nearly  as  possible  to 
cover  the  cost  incurred  by  the  banks  in  performing  the  service 
in  question. 

While  many  difficulties  have  been  encountered  in  some 
places  in  controlling  this  phase  of  banking  competition,  the 
practice  of  agreeing  upon  uniform  charges  has  been  graduallv 

'  See  pp.  593-94  and  597-98. 


468         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

extended  throughout  the  country.  The  adoption  of  the  Federal 
Reserve  Act,  however,  and  the  development  of  a  new  collection 
system,  now  accomplish  the  same  results  by  other  means.' 

3.  Conducting  clearing-house  bank  examinations.  Clearing- 
house bank  examinations  are  of  still  more  recent  development, 
the  first  one  having  been  organized  in  Chicago  on  June  i,  1906. 
The  examination  of  banks  by  an  agent  of  the  clearing-house 
association  constitutes  an  attempt  by  the  banks  themselves  to 
control  and  safeguard  the  interests  of  the  credit  structure  as  a 
whole  through  a  system  of  supervision  which  greatly  reduces 
the  chances  of  bad  banking  practice  and  consequent  banking 
failures.  A  statement  of  the  origin  of  the  system  of  clearing- 
house bank  examinations  in  Chicago  will  best  serve  to  reveal 
the  reasons  for  this  significant  development. 

In  the  autumn  of  1905  it  was  discovered  by  the  federal 
bank  examiner  that  a  large  national  bank  in  Chicago,  of  which 
a  prominent  financier  was  president,  was  insolvent.  The 
president  of  this  bank  was  also  in  control  of  two  state  banking 
institutions  and  it  was  conceded  that  the  three  institutions 
were  involved  in  mutual  difficulties.  The  status  of  affairs  was 
discovered  on  a  Saturday  morning;  but  owing  to  the  fact  that 
.the  money  market  was  in  a  somewhat  strained  condition  at 
the  time,  it  was  deemed  inexpedient  to  make  an  immediate 
pubUc  announcement,  lest  a  "run"  on  these  banks  might  so 
shatter  general  confidence  that  a  financial  panic  of  serious 
proportions  might  be  precipitated.  Accordingly,  the  announce- 
ment was  postponed  until  Monday;  and  during  the  interval  a 
committee  of  leading  bankers  and  business  men  met  with  the 
federal  examiner  to  consider  ways  and  means  of  meeting  the 
situation.  In  order  to  prevent  a  general  loss  of  confidence  in 
Chicago  banks,  these  men  agreed  to  advance  several  millions 
of  dollars  in  order  to  prevent  a  "run"  upon  the  insolvent 
institutions.  The  president  of  the  banks  paid  the  personal 
penalty  of  imprisonment,  but  the  miUions  of  dollars  advanced 
to  prevent  a  general  disruption  of  credit  to  this  day  remain 
largely  unpaid. 

■See  pp.  608-13. 


THE  COMMERCIAL  BANKING  SYSTEM  469 

It  was  from  no  altruistic  motive  that  the  financiers  of 
Chicago  thus  underwrote  the  losses  of  an  erring  member; 
it  was  rather  enhghtened  self-interest  which  dictated  their 
poHcy.  In  the  light  of  this  experience,  however,  it  was  decided 
that  some  means  should  be  developed,  if  possible,  to  prevent 
a  recurrence  of  such  a  disaster.  Many  bankers  and  business 
men  had  for  some  time  been  aware  of  the  fact  that  the 
banks  in  question  were  in  an  unsoimd  condition,  the  funds 
of  these  institutions  having  been  used  for  railroad  and  other 
enterprises  in  which  the  president  was  interested.  It  was 
known  that  these  enterprises  were  in  financial  difficulties  and 
that  the  good  funds  of  depositors  were  being  steadily  diverted 
from  the  financing  of  ordinary  conservative  business  to  the 
rescuing  of  the  bad  funds  already  invested  elsewhere.  Upon 
the  occasion  of  his  previous  examination,  six  months  earher, 
the  federal  bank  examiner  had  not  fuUy  perceived  the  gravity 
of  the  situation — doubtless  because  there  was  juggling  of 
accounts  between  the  state  and  national  institutions.  It  was 
beUeved  therefore  that  the  only  remedy  for  the  situation  was 
to  develop  a  means  whereby  other  banks  could  bring  pressure 
to  bear  to  correct  an  obviously  dangerous  situation,  before  it 
could  get  so  bad  as  to  imperil  public  confidence  in  banking 
institutions  generally.  Accordingly,  the  clearing-house  asso- 
ciation devised  the  system  of  examinations  as  a  means  of 
eliminating  bad  banking  practices  on  the  part  of  any  of  its 
members. 

The  system  devised  for  Chicago  is  in  brief  as  follows: 
A  skilled  examiner  is  employed  by  the  clearing-house  asso- 
ciation for  the  purpose  of  making  annual  examinations  of  all 
the  associated  banks  and  of  the  non-member  institutions  of 
Chicago,  and  such  additional  examinations  as  may  appear  to  be 
necessary  at  any  time.  The  examination  includes  a  verifi- 
cation of  the  assets  and  liabilities  of  each  bank  and  an  investi- 
gation of  the  work  of  each  department.  Upon  the  conclusion 
of  an  examination,  the  examiner  prepares  a  detailed  report, 
in  duplicate,  which  discloses  the  bank's  loans,  bond  invest- 
ments, and  other  assets,  mentioning  particularly  all  loans 


470         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

either  direct  or  indirect,  that  have  been  made  to  officers, 
directors,  or  employees,  or  to  corporations  in  which  they  may 
be  interested.  One  of  these  reports  is  filed  in  the  clearing-house 
in  the  custody  of  the  examiner  and  the  other  is  handed  to  the 
president  of  the  examined  bank  for  the  use  of  its  directors,  thus 
bringing  the  condition  of  the  bank  sharply  to  the  attention 
of  the  responsible  managers  of  the  institution.  A  briefer  and 
less  specific  report,  disclosing  no  essentially  private  information, 
is  also  sent  to  the  clearing-house  committee.  The  clearing- 
house examiner  also,  co-operates  with  federal  and  state  bank 
examiners  and  thereby  increases  the  efficiency  of  their  work 
The  system  thus  inaugurated  in  Chicago  has  been  copied 
in  a  large  number  of  the  leading  cities  of  the  country.  It  has 
been  uniformly  successful,  and  thus  far  no  bank  which  is 
subject  to  the  clearing-house  examination  has  ever  failed.  In 
the  Ught  of  this  record  it  is  not  surprising  that  the  clearing- 
house bank  examination  has  been  called  the  most  constructive 
banking  improvement  that  has  ever  been  developed  as  a 
result  of  private  enterprise.* 

II.    RELATIONS  BETWEEN  BANKS  IN  DIFFERENT 

CITIES 

In  the  evolution  of  the  commercial  banking  system  it  has 
been  found  necessary  for  banks  in  different  cities  to  develop 
what  is  known  as  "correspondent"  relations.  The  principal 
services  rendered  to  each  other  by  correspondent  banks  may 
be  listed  as  follows:  (i)  acting  as  collecting  agencies;  (2)  giving 
each  other  advice  and  information  pertaining  to  financial 
and  business  affairs  in  their  respective  locahties;  (3)  holding 
deposits  of  excess  funds;  (4)  borrowing  from  each  other,  as 
occasion  requires. 

I.  Acting  as  collecting  agencies.  Every  important  bank 
receives  from  its  customers  in  the  daily  course  of  business 
many  checks  drawn  on  banks  in  other  towns  and  cities.    Such 

'  The  devices  that  have  been  developed  for  effecting  mutual  co-operation 
of  clearing-house  banks  in  times  of  financial  crisis  are  discussed  elsewhere, 
See  pp.  533-39- 


THE  COMMERCIAL  BANKING  SYSTEM  471 

checks  are  customarily  at  once  credited  to  the  account  of  the 
depositor  who  presents  them;  and  it  is  accordingly  necessary 
for  the  bank  to  send  them  for  collection  to  the  banks  upon 
which  they  are  drawn.  Before  the  establishment  of  the  Federal 
Reserve  collection  system,  checks  and  drafts  upon  banks  in 
other  cities  were  sent  by  mail  either  to  the  bank  direct  or  to 
some  other  bank  which  would  act  as  an  agent  in  the  process. 
Since  the  old  system  of  collecting  checks  is  now  practically 
obsolete,  it  is  unnecessary  at  this  place  to  describe  the  process 
in  any  detail.^  It  need  only  be  said  that  each  bank  endeavored 
to  collect  its  checks  in  the  easiest  and  cheapest  way  possible. 
Sometimes  this  involved  sending  the  check  direct  to  the  bank 
upon  which  it  was  drawn;  sometimes  it  meant  sending  it  to  a 
correspondent  bank  located  in  the  same  city  as  the  drawee 
bank;  and  sometimes  it  meant  sending  it  to  a  correspondent 
bank  in  another  city,  whence  it  would  be  "relayed"  to  the 
city  where  the  drawee  bank  was  located,  being  sent  either 
direct  to  the  bank  in  question  or  to  a  correspondent  bank, 
whichever  way  was  more  convenient  and  less  costly.  Having 
gradually  developed  without  any  concerted  effort  at  systemati- 
zation,  the  system  was  on  the  whole  very  cumbersome  and 
time-consuming,  and  withal  socially  inefficient  and  expensive. 
Various  improvements  were  being  made,  however,  in  the  years 
inmiediately  preceding  the  adoption  of  the  Federal  Reserve 
System. 

Besides  collecting  checks  and  bank  drafts  for  each  other, 
correspondent  banks  also  render  a  great  deal  of  mutual  service 
in  collecting  business  notes  and  bills  of  exchange.  For  instance, 
a  customer  of  a  bank  in  Grand  Rapids,  Michigan,  may  have  a 
promissory  note  due  from  an  individual  in  Chicago.  The 
process  of  collection  is  greatly  facilitated  if  he  turns  this  note 
over  to  his  bank  for  collection.  The  bank  sends  the  note  to 
its  correspondent  in  Chicago,  which  then  either  details  a 
messenger  to  collect  the  note  at  maturity  or  notifies  the  maker 
that  it  is  due  and  payable  at  the  bank  on  a  stipulated  date, 

'  For  a  description  of  the  Federal  Reserve  collection  system  now  in 
vogue  see  pp.  608-13. 


472  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  procedure  depending  upon  the  terms  of  the  agreement  m 
each  individual  case. 

Another  form  of  collection  involving  the  use  of  correspondent 
banks  is  found  in  connection  with  the  payment  of  principal 
and  interest  on  bonds  and  mortgages.  For  instance,  an  indi- 
vidual in  Bloomington,  Indiana,  may  own  bonds  the  interest 
and  principal  of  which  are  payable  at  the  First  National  Bank 
of  New  York.  As  the  coupons,  and  ultimately  the  principal, 
fall  due,  they  are  presented  to  the  local  bank  in  Blooming- 
ton,  which  sends  them  to  its  correspondent  in  New  York, 
where  they  are  presented  to  the  First  National  Bank  for 
collection. 

It  should  also  be  recalled  at  this  place  that  it  is  through 
the  correspondent  relations  of  banks  that  the  system  of  domestic 
exchanges,  whereby  cash  moves  only  in  the  settlement  of  trade 
and  other  balances  between  different  centers,  is  worked  out.^ 
In  order  to  be  in  a  position  to  sell  bills  of  exchange  to  their 
customers,  local  banks  are  obliged  to  keep  funds  on  deposit  in 
the  financial  centers  with  which  the  business  of  their  constitu- 
ents is  mainly  connected. 

2.  Exchanging  advice  and  information  on  financial  and 
business  affairs.  Correspondent  banks  render  a  great  deal  of 
indirect  service  to  each  other.  The  banks  in  the  larger  cities, 
through  the  publishing  of  monthly  analyses  on  business  con- 
ditions, digests  of  important  legislation,  and  special  reports  on 
various  subjects  from  time  to  time,  which  are  sent  free  to  all 
correspondents,  keep  the  country  bankers — those  who  read — 
posted  on  fundamental  economic  conditions  in  a  fairly  eflFective 
way.  The  city  banker  also  advises  the  country  banker  with 
reference  to  the  standing  of  firms  whose  commercial  paper  is 
being  ofifered  for  sale,  and  with  reference  to  bond  and  other 
investment  opportunities.  The  country  banker,  on  his  part, 
supplies  the  city  correspondent  with  information  on  business 
conditions  in  his  locality  and  on  the  character  and  standing  of 
business  men  in  his  community  with  whom  the  city  banker 
may  have  dealings,  either  directly  or  indirectly. 

*  See  pp.  115-16  above. 


THE  COMMERCIAL  BANKING  SYSTEM  473 

The  co-operation  in  the  handling  of  financial  afiFairs  and  in 
the  dissemination  of  information  on  economic  questions  accom- 
pUshed  through  these  correspondent  relations  is  a  most  impor- 
tant development  from  the  standpoint  of  sound  business  and 
economics. 

3.  Holding  deposits  of  excess  funds.  In  order  to  secure  a 
certain  amount  of  financial  concentration,  or  centralization, 
our  national  banking  laws  have  permitted  the  banks  of  the 
smaller  cities  to  deposit  a  portion  of  their  reserves'  in  the  banks 
of  the  larger  cities.  The  practice  has  been  general  for  the  city 
banks  to  pay  2  per  cent  interest  on  these  reserve  deposits, 
the  banks  being  able  to  do  this  by  virtue  of  the  possibiUties  of  a 
remunerative  employment  of  the  funds  thus  received  in  stock 
exchange  and  other  financial  operations.  Besides  loaning 
a  portion  of  their  legal  reserves,  the  outlying  banks  also  loan 
additional  funds  to  their  city  correspondents  during  periods 
of  slack  business  in  the  country.  Funds  that  would  otherwise 
be  idle  are  thereby  given  employment,  at  a  low  rate  of  interest, 
the  while  remaining  subject  to  call  for  more  remunerative 
investment  as  soon  as  occasion  offers.' 

The  concentration  of  funds  in  financial  centers — ^both 
large  and  small — is  a  striking  phenomenon  of  our  modern 
financial  system.  Professor  Taylor  tells  us,  for  example,  that 
"some  years  ago  in  a  certain  Michigan  village  which  had  a 
factory  with  a  pay-roll  of  $2,000  per  week,  it  proved  necessary 
for  the  local  bank  to  bring  out  the  $2,000  in  cash  from  Detroit 
practically  every  week  in  the  year — that  is,  the  $2,000  having 
been  paid  to  the  workmen,  instead  of  remaining  in  the  village 
ready  for  use  the  next  week,  before  the  time  was  up  foxmd 
its  way  into  Detroit,  whence  it  had  to  be  taken  back  by 
the  banker.  "^ 

New  York  is  the  great  financial  center  of  the  United  States. 
A  large  percentage  of  the  deposits  of  New  York  banks,  in  some 

*  For  details  see  pp.  481-82. 

*  We  shall  later  see  that  this  practice  has  serious  weaknesses  in  times 
of  financial  stress  (p.  531). 

*  F.  M.  Taylor,  Some  Chapters  on  Money  (copyright  1906),  pp.  139-40. 


474  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

cases  more  than  half,  are  bankers'  deposit — funds  sent  in  by 
correspondent  banks  from  all  over  the  country.  An  investi- 
gation made  in  1901  showed  that  on  September  i  of  that  year 
the  New  York  banks  had  more  than  43  per  cent  of  the  net 
bankers'  deposits  of  the  United  States — three  times  the  volume 
of  those  held  by  the  banks  of  Chicago  and  St.  Louis  com- 
bined. 

*  The  dominance  of  New  York  in  this  connection  is  due 
primarily  to  its  position  as  the  great  entrepot  of  trade.  The 
overwhelming  percentage  of  our  foreign  trade,  both  exports 
and  imports,  passes  through  or  is  financed  through  New  York, 
as  a  result  of  which  practically  all  banks  find  it  necessary  to 
keep  funds  on  deposit  there.  In  1890  information  was  secured 
by  the  Comptroller  of  the  Currency  from  3,329  out  of  3,438 
national  banks,  bearing  on  their  financial  relations  with  New 
York.  Of  the  reporting  banks  all  but  three  stated  that  they 
drew  drafts  upon  New  York;  and  the  returns  as  a  whole  showed 
that  the  total  amount  of  drafts  on  New  York  was  61.31  per 
cent  of  all  the  drafts  on  all  the  banks  in  the  country.  This  may 
be  compared  with  9.82  per  cent  of  the  total  that  was  drawn 
against  Chicago  banks.  New  York  is  thus  in  a  sense  the 
clearing-house  for  the  entire  country. 

4.  Borrowing  from  each  other.  The  inter-borrowing  relations 
of  correspondent  banks  have  been  developed  as  a  means  of 
securing  additional  cash  as  occasion  demands.  It  has  often 
been  assumed  that  a  commercial  bank  commonly  relies  upon 
its  maturing  loans  to  provide  it  with  ready  funds  when  needed. 
In  practice,  however,  we  find  that  to  a  large  and  steadily 
increasing  extent — before  the  adoption  of  the  Federal  Reserve 
System — the  banks  of  the  country  borrowed  from  each  other 
by  one  device  or  another  the  fimds  required  for  the  replenish- 
ment of  depleted  reserves. 

This  borrowing  is  accomplished  by  nmnerous  devices.  The 
first,  but  not  the  most  important,  of  these  was  by  the  rediscount 
of  customers'  notes.  If  a  bank  in  Richmond,  Virginia,  needed 
additional  cash  resources,  it  could  sell  the  note  of  one  of  its 
customers  to  its  correspondent  bank  in  New  York,  thus  provid' 


THE  COMMERCIAL  BANKING  SYSTEM  475 

ing  itself  with  the  needed  funds.  This  practice,  however,  was 
characteristically  opposed  by  the  customers  themselves.  It 
appears  to  have  been  assumed  that  banks  should  have  enough 
funds  of  their  own  with  which  to  conduct  their  operations  and 
that  the  selling  of  notes  in  Wall  Street  was  a  sign  either  of 
weakness  or  of  dangerous  speculative  activity. 

As  a  means  of  avoiding  this  unwarranted  criticism  of  the 
practice  of  rediscounting,  the  banks  resorted  to  various  expe- 
dients. One  of  these  was  to  indorse  the  notes  that  were  redis- 
coimted  with  a  lead  pencil  so  that  the  indorsement  could  be 
erased  when  the  note  was  returned  to  the  maker  for  payment. 
Another  and  much  more  common  device  was  for  the  bank 
officials  to  borrow  on  their  own  promissory  notes,  either  with 
or  without  customers'  notes  as  collateral  security.  The  funds 
thus  borrowed  were  then  deposited  in  the  bank,  with  the 
understanding  that  the*  officers  would  not  withdraw  them. 
Another  method  of  securing  funds  from  correspondents  in 
time  of  emergency  was  by  the  sale  of  bonds,  with  an  agreement 
to  repurchase  them  at  the  same  price,  plus  a  fixed  rate  of 
interest.  This  was  a  very  common  practice.  An  operation 
akin  to  the  sale  of  bonds  was  the  loaning  of  bonds  by  one  bank 
to  another  for  use  as  security  for  note  issues,  special  deposits, 
etc.  The  sale  of  commercial  paper  purchased  in  the  open 
market  was  a  final  method  by  which  a  bank  could  increase  its 
reserves,  as  occasion  required.  This  practice  developed  rapidly 
after  the  turn  of  the  century,  and  particularly  after  the  panic 
of  1907.  The  development  of  the  Federal  Reserve  System, 
however,  has,  as  we  shall  see,  largely  rendered  obsolete  all  of 
these  methods  of  securing  additional  funds  with  which  to  meet 
emergency  demands. 

III.    LOANS,  DEPOSITS,  AND  RESERVES 

We  have  already  seen  that  in  commercial  banking  the 
granting  of  a  loan  commonly  gives  rise  to  a  deposit  account, 
and  that  a  commercial  bank  requires  a  cash  reserve  against 
deposits  of  only  moderate  proportions.    We  may  now  consider 


476         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

in  greater  detail  the  interrelations  of  loans,  deposits,  and 
reserves  in  the  commercial  banking  system  as  a  whole. 

If  there  were  only  one  bank  in  a  given  community  and  if 
every  customer  of  this  bank  ordinarily  used  a  checking  account 
as  a  means  of  pa)anent,  a  bank  which  possessed  at  the  beginning 
of  its  lending  operations  a  cash  reserve  of  $100,000  could 
gradually  extend  its  loans  and  create  deposit  accounts  to  many 
times  the  amount  of  its  reserve.  Suppose  we  start  with  tLe 
assumption  that  $100,000  of  loans  are  made,  thus  creating 
deposit  accounts  to  the  extent  of  $100,000  (omitting  for  con- 
venience the  amount  of  the  discount).  If,  as  indicated  in  the 
preceding  chapter,  the  borrowers  of  this  $100,000  write  checks 
for  $100,000  payable  to  other  individuals  in  the  same  com- 
munity and  these  individuals  bring  the  checks  to  this  bank 
for  deposit  in  their  accounts,  it  is  obvious  that  a  total  of 
$100,000  deposits  resulting  from  the  loans  is  still  maintained; 
and  if,  in  turn,  these  new  depositors  write  checks  to  the  amount 
of  $100,000  in  payment  of  obligations  and  the  persons  who 
receive  them  in  their  turn  bring  them  to  this  bank  for  deposit 
to  their  respective  accounts,  the  total  of  $100,000  in  deposits 
still  remains;  although  the  names  appearing  on  the  bank's 
ledger  as  creditors  of  the  bank  are  constantly  shifting. 

Suppose  we  now  assume  that  $200,000  of  additional  loans 
are  made,  creating  thereby  $200,000  of  new  deposit  accounts, 
against  which  checks  are  repeatedly  drawn  and  deposited  by 
those  who  receive  them,  as  in  the  case  of  the  original  $100,000. 
This  bank  would  now  have  on  the  assets  side  $100,000  in  cash, 
^nd  on  the  liabilities  side  total  deposit  accounts  (that  is,  claims 
against  cash)  to  the  extent  of  $300,000.  The  question  may 
now  be  raised,  Is  it  safe  for  a  bank  to  create  deposit  accounts 
of  $300,000,  when  it  has  only  $100,000  of  cash  ?  The  answer 
is  that  it  is  entirely  safe  if,  as  in  the  case  we  have  been  assuming, 
everyone  deposits  the  checks  received  with  the  bank  and  pays 
his  obligations  by  writing  checks  against  his  account  rather 
than  by  withdrawing  specie  for  the  purpose. 

In  practice,  however,  not  everyone  does  refrain  from  drawing 
cash.    A  bank  may  safely  count  on  having  to  redeem  a  certain 


THE  COMMERCIAL  BANKING  SYSTEM  477 

percentage  of  ifs  claims  in  actual  specie.  But  since  this  per- 
centage is  ordinarily  small,  it  is  unnecessary  for  the  bank  to 
carry  a  dollar  in  cash  for  every  dollar  of  claims.  In  practice, 
indeed,  it  has  been  found  that,  typically  speaking,  the  banks 
have  to  keep  only  about  one  dollar  in  cash  for  every  ten  dollars 
of  outstanding  deposits.' 

Suppose  we  assume  now  that  there  are  two  banks  in  a  given 
community;  and  that  when  bank  No.  i  makes  a  loan  of  $100,000 
to  Mr.  A,  the  latter  writes  a  check  in  favor  of  X,  who  deposits 
it,  not  in  the  same  bank,  but  in  bank  No.  2.  In  this  case  the 
loan  made  by  bank  No.  i  gives  rise  to  a  deposit  account  in 
the  name  of  Mr.  X  in  bank  No.  2.  Immediately  speaking, 
the  changes  to  be  made  on  the  balance  sheet  of  bank  No.  2 
are  as  follows:  on  the  liabilities  side,  "Deposits "+$100,000; 
on  the  assets  side,  "Exchanges  for  the  clearing-house" 
+$100,000.  But  when  bank  No.  2  presents  this  check  for 
payment  to  bank  No.  i,  will  it  not  involve  the  following  changes 
on  the  books  of  bank  No.  i:  "Deposits"— $100,000  (deducted 
from  A's  account);  and  "Cash"— $100,000,  the  latter  being 
turned  over  to  bank  No.  2  ?  The  answer  is  that  a  payment  is 
usually  efifected  without  the  movement  of  any  very  great 
amount  of  specie.  The  reason  for  this  is  that  bank  No.  2  is 
also  engaged  in  making  loans  and  creating  deposit  accounts; 
and  we  may  assume  that  Mr.  B  who  received  a  deposit  account 
in  bank  No.  2,  say,  of  $120,000,  writes  a  check  in  favor  of  Y, 
who  deposits  it  in  bank  No.  i.  As  a  result,  bank  No.  i  has 
due  from  bank  No.  2,  $120,000.  Under  these  circumstances 
the  account  can  be  settled  merely  by  shifting  $20,000  of  specie 
from  bank  No.  2  to  bank  No.  i. 

When  we  complicate  the  system  still  further  by  assuming 
that  there  are  a  large  number  of  banks  in  a  given  community 
and  that  each  is  daily  making  loans  and  creating  deposit 
accounts  against  which  checks  are  drawn  and  deposited  (in 
the  main)   in  this  or  other  banks,  we  approach  the  actual 

'  We  shall  presently  see  that  by  virtue  of  a  redepositing  of  reserves  the 
ratio  of  cash  to  deposits  in  the  banking  system  as  a  whole  is  even  smaller 
than  this. 


47^  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

situation  that  exists  in  large  financial  centers.  And,  as  we  have 
seen  in  our  study  of  clearing-house  associations,  in  settling 
the  counter-claims  of  the  associated  banks  only  so  much  cash 
moves  as  is  necessary  to  pay  the  net  balances  between  each 
bank  and  all  the  other  members. 

We  may  now  complicate  the  situation  one  step  further  and 
assume  that  some  of  the  checks  drawn  against  deposit  accounts 
in  the  city  in  question  are  sent  to  individuals  in  ^ther  com- 
munities. The  checks  that  are  drawn  against  community  A 
and  deposited  in  banks  in  community  B  are  entered  on  the 
liabilities  side  of  the  bank  balance  sheets  as  "Deposits"  of  cus- 
tomers and  on  the  assets  side  as  "Due  from  banks."  Now 
will  not  community  A  draw  funds  away  from  community 
B  when  it  presents  these  checks  for  payment?  The  answer 
again  is  no — that  cash  will  move  only  to  efifect  a  settlement  of 
net  balances  which  cannot  be  offset  in  any  way.  Just  as 
balances  between  banks  which  are  members  of  a  clearing-house 
association  are  settled  without  the  movement  of  specie,  so  also, 
by  virtue  of  the  correspondent  relations  that  obtain  between 
banks  in  different  centers,  together  with  the  mechanism  of 
domestic  exchanges,  discussed  elsewhere,*  cash  moves  in  the 
settlement  of  balances  between  banks  in  different  centers  only 
as  a  last  resort. 

The  assumptions  that  we  have  been  making  in  the  preceding 
paragraphs  are  directly  applicable  to  the  facts  of  the  modern 
financial  system.  The  use  of  checks  in  making  payments,  while 
of  gradual  development,  is  now  almost  universal  in  the  larger 
cities  for  all  except  the  smallest  transactions.  Hence  the  ratio 
of  cash  to  deposits — the  reserve  that  must  be  kept — ^has  been  a 
steadily  declining  one.  Under  a  system  where  the  use  of  checks 
as  a  means  of  making  payments  is  practically  universal,  where 
individual  depositors  seldom  present  checks  for  payment  in 
cash,  and  where  banks — whether  in  the  same  or  in  different 
cities — largely  cancel  payments  between  each  other,  it  has  been 
possible  for  the  commercial  banking  system  ordinarily  to  main- 
tain convertibility  of  deposits  into  cash  with  a  very  small  ratio 

« See  chap,  viii,  pp.  115-16. 


THE  COMMERCIAL  BANKING  SYSTEM 


479 


of  reserve  money  to  outstanding  deposit  liabilities.    The  chart 
note  h  accompanying  page  reveals  the  slender,  and  declining, 


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margin  of  cash  reserves  in  the  national  banking  system,  and  it 
also  shows  a  striking  correlation  between  loans  and  individual 
deposits  in  the  system  as  a  whole. 


480         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Deposits  in  the  commercial  hanking  system  are  mainly  a 
result  of  loans.  In  this  analysis  we  have  been  contending 
that  the  commercial  banking  system  creates  deposits.  The 
popular  conception — including  that  of  most  bankers  and 
some  economists — has  always  been  that  the  commercial  bank, 
like  the  savings  institutions,  receives  deposits  and  then  loans 
these  funds  out  to  borrowers — the  reverse  of  what  we  have 
stated  above.  If  this  were  true,  the  tot?'  of  deposits  could 
not  be  greater  than  the  total  cash  resources  of  the  nation; 
for  only  such  funds  could  be  loaned  out  as  were  brought  to 
the  banks  for  deposit.  The  truth  of  the  matter  is,  however, 
that  the  total  of  the  country's  bank  deposits  is  many  times  the 
amount  of  the  total  cash  resources  of  the  country.  Because 
he  considers  only  the  operations  of  his  particular  bank  and  does 
not  look  to  the  working  of  the  system  as  a  whole,  the  typical 
banker  thinks  that,  since  A  shortly  writes  checks  against  the 
deposit  account  that  was  derived  from  a  loan,  there  has  been 
only  a  temporary  increase  of  deposits.  When  the  persons  who 
have  received  these  checks  present  them  to  the  bank  through 
the  receiving  teller's  window  as  deposits  for  their  respective 
accounts,  the  banker  is  inclined  to  look  upon  them  as  funds 
received  by  the  bank  from  customers.  This  is  of  course  particu- 
larly the  case  where  checks  drawn  against  deposit  accounts 
in  bank  No.  i  are  presented  for  deposit  in  bank  No.  2 ;  these  are 
almost  always  regarded  as  funds  received  from  customers.  And 
so  they  are,  of  course,  when  viewed  from  the  standpoint  of 
this  particular  bank.  Their  origin,  however,  goes  back  to  the 
making  of  the  loan  which  gave  rise  to  the  initial  deposit  account. 
One  who  fails  clearly  to  appreciate  that  in  the  banking  system 
as  a  whole  deposits  are  largely  the  result  of  antecedent  loaning 
operations  will  never  gain  a  clear  vmderstanding  of  the  real 
significance  of  commercial  banking  operations. 

Commercial  banks  require  very  small  till  money  reserves. 
One  further  consideration  of  banking  practice  will  serve  to 
throw  additional  light  on  the  problem  of  commercial  banking 
reserves.  As  we  have  already  seen,  every  commercial  bank, 
in  addition  to  creating  deposits  by  the  process  of  making  loans, 


THE  COMMERCIAL  BANKING  SYSTEM  481 

receives  deposits  from  individual  customers  from  day  to  day. 
Some  of  these  latter  deposits  are  in  the  form  of  actual  specie 
which  is  available  as  reserve.  And  from  day  to  day,  also, 
a  large  bank  with  many  customers  will  find  that  it  has  some 
cash  resources  flowing  in  from  the  payment  of  loans.  There  is 
thus  a  continuous,  though  variable,  flow  of  cash  into  the  bank. 
At  the  same  time,  as  we  have  seen,  there  is  also  a  perpetual, 
though  fluctuating,  flow  of  cash  out  of  the  bank  to  meet  adverse 
balances,  pay  depositors,  etc.  If  this  inflow  of  funds  exactly 
coincided  with  the  outflow,  it  would  be  unnecessary  for  the 
bank  to  hold  any  specie  on  hand  for  till  money  purposes. 
They  do  not  exactly  coincide,  however,  and  hence  a  small 
reserve  of  cash  is  required. 

The  amount  of  funds  for  till  money  purposes  which  a 
commercial  bank  must  keep  on  hand  is  still  further  reduced  by 
virtue  of  the  fact  that  in  ordinary  times  a  bank  has  various 
means  of  securing  additions  to  its  cash  in  case  of  need.  All  of 
these  means  have  already  been  discussed  and  accordingly  they 
may  here  be  merely  summarized,  as  follows :  (i)  by  borrowing, 
in  various  ways;  (2)  by  selling  commercial  paper  purchased 
through  commercial  paper  houses;  (3)  by  selling  securities; 
(4)  by  calhng  loans.^  By  virtue  of  these  means  of  seeming  a 
quick  command  of  funds,  a  well-organized  bank  usually  requires 
cash  for  till  money  purposes  only  to  the  extent  of  3  or  4  per 
cent  of  the  total  outstanding  (deposit)  claims. 

Banks  are  required  by  law  to  keep  ultimate  or  liquidation 
reserves.  Banks  are  required,  however,  to  keep  substantially 
larger  reserves  than  are  dictated  by  till  money  needs.  In  the 
interest  of  protecting  bank  depositors  from  loss,  the  law  requires 
the  keeping  of  what  may  be  termed  an  "ultimate"  or  Hquidation 
reserve."  By  virtue  of  this  requirement  the  depositors  are 
certain  to  receive  a  considerable  cash  payment  in  case  the  bank 
becomes  insolvent. 

Before  the  passage  of  the  Federal  Reserve  Act  in  1914,  the 
banks  of  the  central  reserve  cities  were  required  to  keep  a 

'  It  must  be  recalled,  however,  that  New  York  is  the  only  call  loan  market. 
•     » See  pp.  556-57. 


482  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

25  per  cent  reserve,  all  in  their  own  vaults;  those  of  the  reserve 
cities,  25  per  cent,  of  which  one-half  might  be  on  deposit  in 
the  central  reserve  cities;  and  the  country  banks,  15  per  cent, 
of  which  three-fifths  might  be  on  deposit  in  either  the  reserve 
or  central  reserve  cities.  Since  these  reserves  were  minima, 
below  which  the  banks  were  not  permitted  to  cut,  they  were 
in  fact  the  ultimate  or  liquidating  reserves  of  the  banks.  Thus 
a  depositor  in  a  country  bank  was  certain  to  get  at  least  15  cents 
on  the  dollar  in  case  the  bank  should  fail.  But  since  these 
were  ultimate  reserves,  it  is  obvious  that  the  fimds  required 
for  till  money  purposes  had  to  be  in  excess  of  this  amount. 
The  statistics  of  bank  reserves  show  that  the  till  money  reserves 
were  in  fact  usually  very  small  indeed. 

Actual  net  reserves  in  the  hanking  system  as  a  whole  are  much 
less  than  the  nominal  reserve  requirements.  By  virtue  of  the 
dupUcation  of  reserves  which  was  permitted  under  the  national 
banking  law,  the  actual  reserves  were  considerably  smaller 
than  the  above-mentioned  percentages  for  the  different  classes 
of  banks  would  indicate.  A  "country  bank"  in  Bloomington, 
Indiana,  for  example,  had  a  15  per  cent  reserve:  $6,000  in  its 
own  vaults,  and  $g,ooo  on  deposit  with  a  correspondent  bank 
in  Indianapolis,  a  reserve  city.  On  the  basis  of  this  $15,000 
of  reserve,  the  Bloomington  bank  would  have  outstanding 
$100,000  worth  of  deposits.  Of  the  $9,000  which  was  placed 
with  the  Indianapolis  bank,  $4,500  would  be  sent  by  this  bank 
to  a  correspondent  in  New  York  and  would  still  be  counted  as 
reserve.  Thus  on  the  $9,000  of  cash  reserve  received  from 
the  Bloomington  bank  the  Indianapolis  bank  would  expand 
loans  and  create  deposits  to  the  extent  of  $36,000;  and  at  the 
same  time  the  $4,500  which  was  sent  to  New  York  would  there 
serve  as  a  reserve  for  four  times  that  amount,  or  $18,000,  of 
deposits.  Thus  a  total  of  $154,000  of  deposits  would  be  out- 
standing against  $15,000  of  actual  specie.  The  same  cash 
thus  served  simultaneously  as  reserve  in  three  different  places. 

The  table  on  page  521  below  shows  the  ratio  of  cash  to 
deposits  in  the  national  banks  as  a  whole.  It  will  be  seen  that 
the  net  reserve  of  the  system,  while  varying  somewhat  from 


THE  COMMERCIAL  BANKING  SYSTEM  483 

year  to  year,  has  typically  been  below  the  minimum  reserve 
requirements  prescribed  for  individual  banks.  This  phenom- 
enon of  course  reflects  the  duplication  that  is  permitted. 

There  is,  finally,  a  still  further  lessening  of  the  ratio  of  cash 
to  deposits  in  the  bankiug  system  as  a  whole  by  virtue  of  the 
fact  that  there  has  been  a  still  further  duplication  of  reserves 
through  the  connections  of  small  state  banks  with  larger  state 
banks  and  of  both  with  the  national  institutions  of  the  larger 
cities.  In  recent  years — ^prior  to  the  Federal  Reserve  Act — 
the  ratio  of  cash  to  outstanding  obligations  in  all  our  commercial 
banking  institutions,  state  and  national,  has,  in  fact,  been 
considerably  less  than  10  per  cent. 

Under  the  Federal  Reserve  Act  the  reserve  requirements 
for  national  banks  have  been  substantially  reduced,*  and  it  is 
now  possible  for  the  banking  system  as  a  whole  to  conduct  its 
operations  on  a  basis  of  only  4  or  5  per  cent  reserve.' 


IV.    COMMERCIAL  BANKING  AND  THE  SUPPLY  OF 
LIQUID  CAPITAL  OR  CURRENCY 

Having  seen  that  our  commercial  banking  system,  with  its 
slender  basis  of  cash  reserves,  is  ordinarily  safe  by  virtue 
of  the  fact  that  actual  specie  is  seldom  called  for,  and  having 
observed  that  deposits  are  mainly  created  through  the  process 
of  making  loans,  we  may  now  indicate  briefly  some  of  the 
larger  results  of  this  banking  organization.  In  the  analysis 
that  we  were  making  on  page  476  above  we  found  that 
a  commercial  bank  with  $100,000  of  cash  had  expanded 
loans  to  $300,000,  at  which  point  the  reserves  stood  at  33^ 
per  cent.  Since  in  the  commercial  banking  system  as  a 
whole  the  actual  specie  reserves  now  amount  to  only  about 
5  per  cent,  it  is  clear  that  this  policy  of  expanding  loans  and 

'  See  pp.  590-91. 

'  For  a  good  discussion  of  this  subject  see  H.  L.  Reed,"  Credit  Expansion 
under  the  Federal  Reserve  System,"  A.mericq,n  Bconotnic  Review,  VIII 
(1918),  270-82. 


484  THE  FINANCIAL  ORGANIZATION  OF  SOaETY 

creating  new  deposit  accounts  has  developed  to  a  point  where 
there  are  approximately  $2,000,000  of  outstanding  deposit 
accounts  for  every  $100,000  of  cash  reserve.  It  should  be 
borne  in  mind  in  contemplating  this  phenonomen  that  no 
single  bank  can  in  this  fashion  expand  its  loans  and  deposits  as 
much  as  twenty-fold;  for  the  extent  to  which  the  individual 
bank  can  create  deposits  is  limited  by  its  specific  reserve 
requirements.  In  the  evolution  of  our  commercial  banking 
system,  however,  with  the  redepositing  of  reserves  that  has 
been  permitted,  it  has  come  about  that  the  commercial  banks 
as  a  whole  have  expanded  the  volume  of  their  Uquid  resources 
about  twenty  times. 

It  may  be  said,  indeed,  that  the  commercial  banking 
system  as  a  whole  gathers  together  a  considerable  proportion  of 
the  monetary  resources  of  the  nation  and  organizes  them  in 
such  a  way  as  to  expand  manyfold  the  volume  of  loanable 
funds.  The  cash  assets  of  the  banks  are  assembled,  as  is 
indicated  in  the  charts  on  pages  134  and  136,  by  two  principal 
avenues — ^by  ordinary  capital  contributions  in  the  form  of 
cash  and  by  customers'  deposits  of  specie  and  lawful  paper 
money.  Through  the  process  of  making  loans  and  creating 
deposit  accounts,  the  commercial  banking  system  in  effect 
multipUes  these  cash  resources  by  twenty,  with  a  resulting 
enormous  increase  in  the  supply  of  liquid  capital. 

The  commercial  hanking  system  supplies  a  very  important 
part  of  the  circulating  medium.  Emphasis  has  been  placed 
upon  the  work  of  the  commercial  banking  system  in  expanding 
the  volume  of  liquid  capital  or  loanable  funds.  From  another 
point  of  view  this  merely  means  that  the  commercial  banking 
system  has  served  to  give  us  a  vastly  increased  quantity  of 
currency;  it  has  furnished  much  the  largest  portion  of  present- 
day  circulating  media.  What  now  is  the  significance  of  this 
addition  to  our  monetary  supply? 

We  have  already  seen  that  from  the  standpoint  of  ordinary 
exchange  operations  the  checking  system  is  usually  much 
more  convenient  than  either  metallic  or  paper  money.  And 
from  the  standpoint  of  economic  cost,  checks  and  bank  notes 


THE  COMMERCIAL  BANKING  SYSTEM  485 

provide  very  inexpensive  substitutes  for  metallic  currency. 
But  by  all  odds  the  most  significant  aspect  of  deposit  currency 
is  the  net  addition  that  it  constitutes  to  our  total  monetary 
supply.  Concretely,  in  the  absence  of  the  commercial  banking 
mechanism,  the  total  currency  supply  of  the  United  States 
on  February  i,  1920,  would  have  been  $3,672,069,502.  Including 
bank  notes  and  deposit  currency,  it  was  about  $29,000,000,000. 

One  of  the  most  vital  and  controversial  questions  in  eco- 
nomic literature  is  the  effect  of  this  increase  in  our  monetary 
supply  upon  the  efficiency  of  wealth  production  and  upon  the 
level  of  prices.  Has  the  evolution  of  this  commercial  banking 
currency  been  attended  merely  by  a  rise  in  the  level  of  prices, 
with  no  increase  in  production,  or  has  the  multiplication  of  the 
volume  of  loanable  currency  that  has  been  effected  tended  to 
stimulate  production  and  increase  the  wealth  of  nations  ? 

Two  schools  of  thought  have  developed,  the  one  contending 
that  the  quantity  of  money  is  a  matter  of  entire  indifference 
and  that  the  net  result  of  the  creation  of  deposit  currency  is 
merely  to  change  the  price-level;  the  other  holding  that  under 
certain  circumstances  an  increase  in  the  supply  of  deposit 
currency  facilitates  productive  operations,  particularly  in 
connection  with  the  creation  of  new  supplies  of  capital  goods. 
In  this  elementary  treatise,  however,  we  can  go  no  further  than 
to  suggest  the  problem  of  the  relation  of  deposit  currency  to 
prices;  its  fuller  exposition  Hes  in  the  field  of  advanced  study. 
It  may  be  pointed  out,  however,  that  those  who  argue  that  an 
increase  in  the  supply  of  bank  currency  serves  only  to  raise 
prices  usually  conceive  of  money  only  as  a  medium  for  exchan- 
ging goods  that  have  already  been  produced;  they  regard  deposit 
currency  as  of  use  only  in  faciHtating  the  flow  of  goods  fron 
producer  to  consumer. 

Whatever  may  be  the  ultimate  price  consequences  of  our 
evolving  commercial  banking  mechanism,  they  can  be  intel- 
ligently apprehended  only  when  one  approaches  the  study  with 
a  clear  appreciation  of  the  undoubted  fact  that  the  commercial 
banking  system  is  fundamentally  related  to  the  productive  no 
less  than  to  the  exchange  process,  to  the  raising  of  fixed  no 


486  THE  FINANCIAL  ORGANIZATION  OF  S0CIE1'\' 

less  than  to  the  raising  of  working  capital,  and  to  the  functioning 
of  other  financial  institutions  no  less  than  to  the  fimctioning 
of  business  organizations  generally. 

V.    COMMERCIAL  BANKING  AND  THE  GENERAL 
ECONOMIC  ORGANIZATION 

The  charts  on  pages  134  and  136,  together  with  the  dis- 
cussion of  the  various  purposes  for  which  commercial  banks 
extend  credit,  outlined  in  chapter  xix,  indicate  the  dominant 
position  that  the  commercial  banking  system  occupies  in  the 
entire  financial  structure.  Our  financial  fabric  as  a  whole  is, 
moreover,  so  constructed  and  operated  as  to  concentrate  a 
very  large,  and  a  steadily  increasing,  percentage  of  our  "  lawful 
money"  in  the  vaults  of  commercial  banks  rather  than  in  those 
of  other  financial  agencies.  The  bond  houses,  handling  billions 
of  dollars'  worth  of  investments  annually,  require  relatively 
little  actual  money.  Their  business  is  largely  that  of  inter- 
mediary, and  their  transactions  are  nearly  always  effected  on 
the  part  of  both  their  customers  and  themselves  by  checks  on 
commercial  banks.  Similarly,  the  insurance  companies  require 
specie  or  legal  tender  in  almost  negligible  quantities.  Such 
"  funds  on  hand  "  as  they  are  required  to  hold  may  be  kept  in  the 
form  of  a  checking  account  with  a  commercial  bank.  The  sav- 
ings banks  likewise  hold  at  best  very  small  cash  reserves;  to  be 
exact,  one-tenth  of  i  per  cent  on  the  average  in  1909 — merely 
till  money.  Our  savings  banks  also  characteristically  look 
to  the  commercial  institutions  for  accommodation  in  case  of 
need.  Accordingly  all  these  institutions  are  most  intimately 
related  to  and  dependent  upon  the  successful  functioning  of 
the  commercial  banking  system.  They  are  dependent  upon 
the  solvency  of  the  commercial  banking  institutions  for  the 
safety  of  their  deposited  funds;  and  they  are  dependent  upon 
the  lending  power  of  the  commercial  banking  institutions 
for  the  conduct  of  their  business  from  day  to  day.  An  inade- 
quacy of  commercial  banking  funds  means  a  direct  lessening  of 
the  underwriting  activities  and  other  operations  of  investment 


THE  COMMERCIAL  BANKING  SYSTEM  487 

bankers;  it  means  an  impairment  of  the  ability  of  the  savings 
institutions  and  of  the  insurance  companies  to  meet  their 
financial  engagements  and  obligations.  And  whenever  there  is 
a  breakdown  of  this  complicated  commercial  banking  mechan- 
ism and  an  attendant  collapse  of  the  great  superstructure  of 
credit  that  has  been  reared  upon  the  attenuated  reserves  of 
specie,  the  entire  fijiandal  mechanism  is  thrown  completely 
out  of  gear." 

All  business  is  fundamentally  dependent  upon  the  commer- 
cial banking  system.  Not  only  does  the  commercial  banking 
system  constitute  the  center  of  the  entire  financial  structure, 
but  it  Ues  as  well  at  the  basis  of  all  modem  business  operations. 
It  is,  indeed,  the  foundati(3n  of  the  whole  complex  financial 
and  economic  organization  of  modem  society.  Every  business 
concem,  practically  speaking,  is  dependent  directly  or  indirectly 
upon  the  commercial  banks  both  for  the  safety  of  deposited 
funds — ^whether  in  commercial  or  in  savings  institutions — and 
also  for  a  continuous  supply  of  borrowed  capital.  Let  it  once 
more  be  emphasized  and  let  it  again  be  visualized  by  reference 
to  the  chart  on  page  136  that  the  operations  of  the  commercial 
banks  are  not  confined  merely  to  making  loans  for  working 
capital;  through  the  loans  which  they  make  to  other  financial 
institutions  and  through  direct  loans  to  corporations  for  fixed 
capital  purposes,  and  especially  through  the  purchase  of  cor- 
porate securities,  real  estate  mortgages,  etc.,  and  through  loans 
on  collateral,  they  are  also  vitally  related  to  the  raising  of 
fixed  capital  and  to  the  entire  investment  market. 

Especial  emphasis  is  here  placed  upon  the  relation  of  the 
commercial  banking  system  to  the  furnishing  of  funds  for 
fixed  capital  purposes,  for  the  reason  that  practically  all  banking 
theory  as  well  as  banking  legislation  is  based  on  the  assumption 
that  the  function  of  commercial  banks  is  merely  to  make  loans 
for  short-time  commercial  purposes — that  the  engaging  in 
investment  operations  is  outside  the  legitimate  field  of  com- 
mercial banking  and  dangerous  in  its  consequences.  We  shall 
have  something  to  say  in  the  following  chapter  on  the  possible 

'  Financial  crises  and  panics  will  be  considered  in  the  following  chapter. 


488         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

dangers  involved.  For  the  present  we  may  merely  emphasize 
what  has  already  been  indicated/  namely  the  fact  that  the 
commercial  banking  system  does  furnish  a  large  part  of  the 
funds  required  for  fixed  capital  purposes  and  that  the  in- 
vestment markets  are  absolutely  dependent  upon  commer- 
cial banking.  The  writer  has  elsewhere  made  an  analysis 
of  the  investment  business  of  national  banks;  and  it  appears 
that  approximately  50  per  cent  of  all  the  loans  that  are  made  by 
national  and  state  banks  and  trust  companies  are  devoted  to 
investment  uses  and  that  when  direct  investments  in  securities 
are  included,  in  the  neighborhood  of  two-thirds  of  the  credit 
extended  by  the  commercial"  banks  goes  for  ^ed  rather  than 
for  working  capital.'  The  exigencies  of  war  finance  during  the 
last  four  years  have  doubtless  considerably  Increased  these 
percentages. 

Any  failure  of  the  commercial  banking  system  to  function 
normally  therefore  has  its  direct  effect  upon  every  phase  of 
financial  and  business  activity.  There  are  times  when  an 
inadequacy  of  commercial  banking  funds  acts  as  a  serious 
limiting  factor  upon  all  commercial,  industrial,  and  financial 
operations;  and  there  are  occasions  when  a  collapse  of  the 
superstructure  of  commercial  banking  credit  virtually  paralyzes 
for  a  considerable  period  of  time  the  entire  economic  organi- 
zation. We  shall  consider  specifically  in  the  next  chapter  the 
occasions  on  which  the  commercial  banking  system  does  fail  to 
accommodate  itself  to  the  varying  needs  of  business,  while  in 
the  chapter  on  the  Federal  Reserve  System,  which  follows, 
we  shall  discuss  the  remedies  that  have  been  worked  out  for  the 
elimination  of  some  of  the  weaknesses  that  existed  under  the 
national  banking  system  prior  to  1914. 

'  See  pp.  401-2  above. 

'  See  Journal  of  Political  Economy,  XXVI  (1918),  638H53. 


THE  COMMERCIAL  BANKING  SYSTEM  489 

QUESTIONS  FOR  DISCUSSION 

I.      CLEARING-HOUSE    RELATIONS 

1.  For  what  various  reasons  do  banks  in  a  given  community  have  to 
make  settlements  with  each  other  ? 

2.  Why  cannot  the  total  amount  due  to  the  clearing-house  exceed 
the  total  amount  due  from  the  clearing-house  ? 

3.  State  the  advantage  in  tradmg  some  checks  directly  rather  than 
presenting  them  through  the  clearing-house.  Why  should  the 
figures  representing  such  checks  still  be  sent  through  the  clearings  7 

4.  What  is  the  amount  of  the  present  daily  clearances  in  New  York 
City  ?  in  Chicago  ?  (Consult  the  financial  pages  of  the  news- 
papers.) 

5.  What  advantages  has  the  clearing-house  certificate  over  cash 
as  a  means  of  settling  clearing-house  balances  ? 

6.  What  is  the  advantage  of  settling  clearing-house  balances  through 
the  Federal  Reserve  bank  rather  than  by  means  of  clearing-house 
certificates  ? 

7.  How  can  a  bank  that  is  not  a  member  of  a  clearing-house  collect 
items  on  other  banks  in  the  same  community  ? 

8.  It  is  sometimes  said  that  the  "clearings"  afford  an  excellent 
barometer  of  business  conditions.  Why  ?  Which  would  be  better 
for  this  purpose,  the  New  York  or  the  Chicago  clearings  ?    Why  ? 

9.  Which  seems  to  you  to  have  been  the  most  potent  reason  for 
the  establishment  of  the  New  York  Clearing-House,  the  expense 
and  loss  of  time  in  settling  balances,  or  the  competitive  evils 
resulting  from  the  fact  that  balances  were  settled  only  weekly  ? 

10.  Do  you  regard  the  fixing  of  uniform  interest  rates  on  deposits  by 
clearing-house  associations  as  a  justifiable  practice  ?  Does  it  not 
smack  of  monopoly  ? 

11.  Why  have  clearing-house  banks  almost  universally  failed  to 
make  definite  agreements  as  to  rates  on  loans  ? 

12.  Do  you  find  that  there  are  wide  variations  in  the  discount  rates 
of  local  banks  ?     (See  quotations  in  the  daily  press.) 

13.  It  has  been  frequently  suggested  that  a  committee  of  bankers 
should  be  appointed  by  the  clearing-house  to  meet  every  day 
and  determine  what  the  rate  of  call  loans  should  be  for  that  day, 
and  make  this  rate  binding  on  all  the  member  banks  and  the 
institutions  that  clear  through  them.     The  membership  M  this 

.  committee  under  such  a  system  would  be  changed  frequently, 
say  once  every  month.  Would  such  a  plan  possess  any  advan- 
tages ?    Would  it  not  be  monopolistic  ? 


49©  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

14.  Why  have  many  clearing-houses  been  led  to  adopt  uniform 
charges  on  collections  ?  Why  is  such  a  paethod  hard  to  enforce  ? 
Is  it  not  an  attempt  to  restrain  trade  ? 

15.  Is  it  your  opinion  that  the  banks  make  a  great  deal  of  profit 
on  their  collections  ? 

16.  Does  the  development  of  these  various  regulations  and  agree- 
ments indicate  that  there  is  the  same  tendency  in  the  banking 
as  in  other  fields  to  eliminate  ruinous  competition?  Do  you 
feel  that  there  is  grave  danger  of  monopoly  here  ? 

17.  What  caused  the  resort  to  clearing-house  bank  examinations? 
What  right  has  an  association  of  banks  to  examine  the  affairs  of 
an  individual  bank?  Would  it  have  any  right  to  examine  a 
non-member  bank  ? 

18.  What  advantage  has  a  clearing-house  examination  over  a  govern- 
ment examination  ? 

19.  Do  you  believe  that  one  can  properly  say  at  the  present  time 
that  our  banks  are  independent,  competing  institutions,  "looking 
out  solely  for  number  one"  ? 

n.      RELATIONS  BETWEEN  BANKS  IN  DIFFERENT  CITIES 

20.  Enumerate  the  various  occasions  for  making  payments  in  other 
towns  and  cities. 

21.  Enumerate  as  many  ways  as -possible  in  which  a  payment  in 
another  city  may  be  made.  Do  all  these  ways  involve  the  use 
of  banks,  directly  or  indirectly  ? 

22.  What  is  meant  by  "correspondent"  banks? 

23.  A  in  Chicago  owes  B  in  Grand  Rapids  $1,000.  Upon  the  matu- 
rity of  the  loan,  B  places  the  note  with  his  bank  in  Grand  Rapids 
for  collection.    Describe  the  process. 

24.  What  kinds  of  items  do  correspondent  banks  collect  for  each 
other?  Is  the  service  thus  rendered  to  customers  of  much 
importance  ?  State  concretely  how  such  items  would  be  collected 
in  the  absence  of  a  banking  system. 

25.  In  exchanging  advice  and  information  on  financial  and  business 
affairs,  do  you  think  the  small-town  country  banks  can  be  of 
any  particular  service  to  their  city  correspondents  ? 

26.  Read  through — in  your  Ubrary — some  of  the  monthly  news 
letters  (or  magazines)  published  by  such  institutions  as  the 
National  City  Bank  of  New  York,  the  Guarantee  Trust  Com- 
pany of  New  York,  the  National  Bank  of  the  Republic  of  Chicago, 
etc.,  and  attempt  to  estimate  the  importance  of  the  service  thus 
rendered. 


THE  COMMERCIAL  BANKING  SYSTEM  491 

ij.  For  what  reasons  did  the  national  banking  law  permit  the  banks 
of  the  smaller  cities  to  deposit  a  pwrtion  of  their  reserves  in  the 
banks  of  the  larger  cities  ? 

28.  Why  is  there  so  strong  a  tendency  for  funds  to  concentrate  in 
the  financial  centers  ? 

29.  Explain  why  New  York  has  become  the  great  financial  center  of 
the  United  States. 

30.  What  advantages  ordinarily  accrue  to  the  small-town  banks 
from  the  deposit  of  both  reserve  and  "excess"  funds  in  the 
financial  centers?  What  advantages  accrue  to  the  banks  in 
the  large  centers  ? 

31.  Turn  to  the  financial  statements  on  pages  364  and  365  and 
explain  the  items  "Due  to  banks"  and  "Due  from  banks." 

32.  For  what  reasons  do  correspondent  banks  borrow  from  each 
other  ? 

33.  Turn  to  the  financial  statements  on  pages  364  and  365  and 
indicate  what  accounts  have  arisen  as  a  result  of  inter-bank 
borrowing  operations. 

m.      LOANS,   DEPOSITS,   AND  RESERVES 

34.  A  bank  has  $1,000,000  in  cash  derived  from  the  following  sources: 
(a)  shareholders'  contributions,  (b)  deposits  of  customers,  and 
(c)  earnings.  If  the  law  requires  this,  bank  to  hold  a  cash  reserve 
of  13  per  cent,  show  how  many  additional  deposits  it  may  create 
through  the  process  of  making  loans. 

35.  What  bearing  does  the  extent  to  which  business  men  and  people 
generally  employ  checks  in  meeting  their  obligations  have  upon 
the  volume  of  bank  reserves  that  is  necessary  ? 

36.  What  bearing  does  the  development  of  the  clearing-house  asso- 
ciations have  upon  the  amount  of  reserve  which  each  bank 
must  hold  ? 

37.  What  bearing  does  the  development  of  the  domestic  and  foreign 
exchanges  have  upon  the  amount  of  reserves  that  banks  should 
hold? 

38.  "The  more  highly  organized  the  banking  and  credit  system 
becomes,  the  smaller  the  cash  reserves  that  are  required." 
Explain  this  statement. 

39.  How  do  you  account  for  the  fact  that  individual  deposits  in  the 
national  banks  as  a  whole  are  practically  equal  in  amount  to 
loans  and  discounts?  Are  deposits  always  greater  or  always 
less  than  loans  and  discounts  ?    (See  the  chart  on  p.  479.) 


492  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

40.  "A  bank  cannot  earn  dividends  by  keeping  the  funds  of  its 
depositors  lying  idle  in  its  vaults.  The  great  problem  of  banking 
is  to  find  investments  which  will  keep  these  funds  hquid. " 
Is  this  an  accurate  statement  of  the  essential  problem  of  a 
commercial  bank  ? 

41.  Would  you  say  that  a  bank  makes  loans  out  of  its  reserves,  or 
on  the  basis  of  its  reserves  ? 

42.  State  in  your  own  words  the  purjwse  of  a  cash  reserve,  differ- 
entiating between  ultimate  and  "till  money"  reserves. 

43.  What  determines  the  amount  of  "till  money"  that  is  required 
by  a  bank  ? 

44.  "The  more  highly  organized  the  banking  system  becomes,  the 
smaller  the  reserves  that  are  required."    Why? 

45.  Turn  to  the  table  on  page  521  and  ascertain  the  reserve  ratio 
in  the  national  banks  as  a  whole  during  the  years  there  in  ques- 
tion. How  do  you  explain  the  fact  that  they  are  much  below 
the  minimum  reserve  requirements  for  the  different  classes  of 
banks  ?       ' 

IV.      THE  COMMERCIAL  BANKING  SYSTEM  AND  THE  SUPPLY  OF 
LIQUID  CAPITAL 

46.  Turn  to  the  chart  on  page  136  and  indicate  in  what  ways  the 
commercial  banking  system  supports  the  other  financial  insti- 
tutions which  make  up  the  financial  structure  of  society.  Indi- 
cate the  probable  effects  upon  each  of  these  institutions  of  a 
failure  of  the  commercial  banking  system  to  function  in  its 
customary  way. 

47.  Show  in  what  ways  commercial  banking  is  related  to  the  invest- 
ment or  fixed-capital  aspect  of  business  enterprise.  Without 
the  commercial  banking  system,  would  it  be  possible  for  cor- 
porations to  raise  the  volume  of  funds  required  for  their  opera- 
tions? 

48.  "The  outstanding  feature  of  the  commercial  banking  system  is 
the  ability  to  gather  together  a  large  portion  of  the  monetary 
reserves  of  the  nation  and  organize  them-  in  such  a  way  as  to 
multiply  many  times  the  volume  of  loanable  funds. "  Of  what 
significance  is  this  fact  ? 

40.  Make  a  tentative  statement  of  your  views  as  to  the  probable 
relationship  of  the  increased  supply  of  currency  that  is  created  by 
the  commercial  banking  system  to  the  level  of  prices.  State 
also  what  doubts  or  questions  in  connection  with  this  problem 
occur  to  you. 


THE  COMMERCIAL  BANKING  SYSTEM  493 

REFERENCES  FOR  FURTHER  STUDY 

Agger,  Eugene  E.:  Organized  Banking,  chap.  vi. 

Davenport,  H.  J.:  The  Economics  of  Enterprise,  pp.  259-65. 

Dunbar,  Charles  F.:  Chapters  in  the  History  and  Theory  of 
Banking,  3d  edition,  revised  and  enlarged  by  O.  M.  W.  Sprague, 
chaps,  iv  and  vii. 

Fisher,   Irving:  The  Purchasing  Power  of  Money,  pp.   33-47. 

Holdsworth,    John   Thorn:    Money   and   Banking,    chap.    xiv. 

Moulton,  Harold  G. :  Principles  of  Money  and  Banking,  Part  11, 
pp.  94-123. 

Phillips,  Chester  A.:  Readings  in  Money  and  Banking,  chap.  xix. 

Scott,  William  A.:  Money  and  Banking,  pp.  11 6-21. 

White,  Horace:  Money  and  Banking,  Book  HI,  chap.  iii. 


CHAPTER  XXIII 

COMMERCIAL  BANKING  AND  THE  EBB  AND 
FLOW  OF  BUSINESS 

In  the  chapters  immediately  preceding  we  have  endeavored 
to  reveal  the  nature  of  commercial  banking  operations  and  the 
general  significance  of  the  commercial  banking  system  that 
has  been  gradually  evolved.  In  all  this  discussion  business 
conditions  have  been  taken  for  granted;  and  the  reader  may 
well  have  assumed  that  the  demands  which  business  enterprises 
make  upon  the  commercial  banking  system  for  fixed  and  work- 
mg  capital  are  constant  in  amount,  except  of  course  insofar 
as  there  is  a  gradual  expansion  in  the  volume  of  business  and 
hence  in  the  volume  of  funds  required  for  its  conduct.  The 
truth  is,  however,  that  business  is  never  stable  and  the  demand 
for  liquid  capital  is  accordingly  ever  fluctuating.  As  one 
writer  so  well  puts  it:  "In  the  real  world  of  business,  affairs 
are  always  undergoing  a  cumulative  change,  always  passing 
through  some  phase  of  a  business  cycle  into  some  other  phase. 
....  In  fact,  if  not  in  theory,  a  state  of  change  in  business 
conditions  is  the  only  normal  state. "' 

There  are  two  species  of  fluctuations  in  business  activity, 
the  one  seasonal  and  the  other  cyclical.  In  this  chapter  we 
shall  consider  the  relations  of  the  commercial  banking  system 
to  the  varying  needs  of  business  as  determined  both  by  seasonal 
exigencies  and  by  the  phenomena  of  the  larger  cycles  in  the, 
ebb  and  flow  of  industrial  activity.  We  shall  endeavor  to 
ascertain  the  nature  of  the  demands  that  are  placed  upon  our 
banking  institutions  in  the  alternate  periods  of  seasonal  activity 
and  dulness,  prosperity  and  depression,  and  the  efiiciency  with 
which  these  varying  demands  are  fulfilled.  So  far  as  the 
banking   phase   of   the   problem   is   concerned,   we    shall    in 

•  Wesley  C.  Mitchell,  Business  Cycles,  p.  86. 

494 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES        495 

the  present  chapter  consider  the  situation  as  it  existed  before 
the  establishment  of  the  Federal  Reserve  System;  for  only  by 
disclosing  the  weaknesses  in  our  baming  organization  before 
1914  shall  we  be  in  a  position  to  understand  the  purpose  of  the 
Federal  Reserve  System  and  to  appraise  its  adaptability  to  the 
onerous  requirements  that  are  placed  upon  it, 

I.    SEASONAL  VARIATIONS  IN  THE  DEMAND  FOR 

FUNDS 

Within  the  course  of  a  given  year  there  are  normally  numer- 
ous ups  and  downs  in  business  and  trade  and  an  accompany- 
ing tension  and  ease  in  the  demand  for  loanable  funds.  The 
best  means  of  indicating  the  nature  and  the  causes  of  these 
seasonal  fluctuations  is  to  outline  briefly  the  actual  variations 
in  the  demand  for  funds  that  occur  in  some  of  our  leading 
financial  centers.  These  will  be  found  to  reflect  pretty 
accurately  the  fluctuations  of  business  as  a  whole. 

The  fluctuations  in  the  demand  for  funds  in  the  New  York 
and  Chicago  money  markets,  which  move  very  closely  together, 
will  best  serve  our  purpose.  In  these  markets  there  are  nor- 
mally five  distinct  seasonal  movements,  as  follows:  (i)  from 
early  January  until  the  middle  of  February;  (2)  from  the 
middle  of  February  to  the  early  part  of  April;  (3)  from  the 
early  part  of  April  to  about  August  first;  (4)  from  August  first 
to  about  October  first;  (5)  from  October  first  to  the  end  of 
the  year. 

The  first  movement  is  characterized  by  a  slack  demand  for 
funds  and  by  correspondingly  low  interest  rates.  This  is 
attributable  to  the  fact  that  the  crop  movement  with  its  great 
demand  for  money  in  the  West  and  South  is  past  and  has  been 
followed  by  a  heavy  flow  of  cash  from  the  country  banks  to 
the  primary  money  markets.  At  the  same  time  the  demand 
for  funds  is  relatively  slight — partly  because  of  a  natural 
relaxation  after  the  holiday  season  and  the  meeting  of  the  large 
interest  and  principal  payments  on  corporate  securities  that 
occurs  on  January  i.    Business  in  general  is  characteristically 


/96  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

dull  for  an  interval  following  the  taking  of  annual  inventories 
and  pending  the  opening  of  the  spring  manufacturing  and 
trading  season. 

The  second  seasonal  movement,  which  is  marked  by  a 
substantial  increase  in  the  demand  for  funds  and  by  rising 
interest  rates,  is  largely  attributable  to  the  monetary  require- 
ments of  producers  and  manufacturers  in  preparation  for  the 
spring  trade.  This  demand  is  supplemented,  particularly  in 
the  latter  part  of  the  period,  by  the  requirements  of  the  agri- 
cultural regions  in  the  South  and  Southwest,  incident  to  the 
planting  of  crops.  There  are  also  temporary  influences  at  work, 
such  as  the  settlement  of  farm  loan  obHgations  on  the  first  of 
March  and  the  quarterly  dividend  and  interest  payments  on 
the  first  of  April. 

The  third  important  seasonal  variation  shows  a  weakening 
money  market  in  April  and  May  and  a  genuine  depression  in 
June  and  July.  There  is,  however,  a  temporary  increase  in 
the  demand  for  funds  about  the  first  of  July  incident  to  the 
large  semiannual  interest  and  dividend  payments.  This  third 
period  at  its  beginning  reflects  the  declining  demand  for  funds 
by  the  manufacturing  and  producing  interests  of  the  industrial 
centers;  and  in  its  later  stages  it  reflects,  also,  the  general 
plethora  of  currency  that  exists  after  crops  have  been  planted 
and  there  has  been  a  return  of  cash  to  Chicago  and  New  York 
from  the  country  districts. 

The  fourth  season  is  generally  referred  to  as  the  "crop- 
moving"  period.  The  demand  for  funds  in  the  country  dis- 
tricts for  the  paying  of  farm  labor,  the  storing  of  grain,  and  the 
moving  of  produce  to  the  primary  markets  calls  for  an  extensive 
outflow  of  funds  from  the  financial  centers  to  the  interior. 
At  the  same  time  the  demand  from  producing  and  manu- 
facturing enterprise,  which  is  making  ready  for  the  fall  trade, 
is  very  heavy  in  the  industrial  centers,  thus  bringing  added 
pressure  to  bear  on  the  New  York  and  Chicago  money  markets. 

The  fifth  and  last  seasonal  period  is  less  marked  than  any 
of  the  others.  In  brief,  it  may  be  said  that  it  begins  with  a 
slight  easing  in  the  demand  for  funds,  owing  to  the  completion 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       497 

of  the  fall  manufacturing  business  and  to  the  gradual  passage 
of  agricultural  produce  from  producers  to  ultimate  consumers. 
The  date  at  which  this  easing  of  demand  begins  varies  somewhat 
with  climatic  conditions  in  the  different  years,  and  also  with 
the  adequacy  of  transportation  facilities.  Typically  speaking, 
however,  it  may  be  said  that  the  peak  of  demand  is  reached 
about  the  first  of  October,  that  the  western  movement  of  cash 
falls  off  rapidly  in  November,  and  that  by  December  a  return 
flow  of  funds  to  the  industrial  centers  has  usually  begun.  Other 
factors  bearing  on  the  situation  at  this  period  are  the  normally  . 
low  gold  imports  during  December  and  the  making  of  large 
deposits  by  the  federal  Treasury  in  the  national  banks  of 
New  York  and  Chicago  during  the  months  of  October,  Novem- 
ber, and  December.  A  stiffening  demand  for  funds  is  to  be 
noted  after  the  middle  of  December,  owing  to  the  currency 
requirements  of  the  holiday  season  and  the  payments  of  interest 
and  principal  on  corporate  and  other  indebtedness  on  the 
first  of  January.  On  the  whole  this  last  period  is  one  of  high 
interest  rates  and  relatively  tight  money.  Neither  a  distinctly 
upward  nor  a  distinctly  downward  movement,  it  is  rather  a 
transitional  period  between  the  excessive  demands  of  the 
crop-moving  period  and  the  season  of  mid- winter  duln.ess. 

Seasonal  movements  in  St.  Louis,  New  Orleans,  San  Fran- 
cisco, and  other  centers  differ  only  in  time  and  in  extent  from 
those  in  New  York  and  Chicago,  the  variations  being  attrib- 
utable to  differences  in  climatic  and  other  local  conditions.* 

The  chart  on  page  498  shows  the  monthly  variations  in 
reserves  and  in  the  ratio  of  reserves  to  deposits  in  the  New  York 
clearing-house  banks  between  1890  and  1908.  It  will  be 
observed  that  reserves  increase  in  every  period  of  slack 
demand  for  loans  and  decrease  in  every  period  of  active 
demand.  The  changes  in  the  ratio  of  reserves  to  deposits 
are  accompanied  by  changes  in  the  rates  of  interest  on  loans. 

Our  currency  supply  has  not  been  sufficiently  elastic.  The 
seasonal  variations  in  the  demand  for  funds  in  the  primary 

'  See  E.  W.  Kemmerer,  Seasonal  Variations  in  the  Relative  Demand  for 
Money  and  Capital  in  the  United  States.  (National  Monetary  Commission, 
1910.) 


498 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


markets  require  a  certain  amount  of  elasticity  in  the  currency 
supply.  To  some  extent  such  elasticity  has  been  obtained  by 
a  process  of  shifting  funds  from  one  section  of  the  country  to 
another.  As  noted  in  chapter  xxi,  this  is  in  considerable 
measure  accomplished  through  the  intermediation  of  commercial 
paper  houses.  But  in  periods  of  very  active  demand  for  money, 
particularly  during  the  crop-moving  season,  which  coincides 
with  the  period  of  producing"  and  manufacturing  goods  for  the 

Reserves  and  Ratios  of  Reserves  to  Deposits  of  the  New  York 
City  Clearing-House  Banks,  1890-1908 


ReMfVei 

(000.000) 

I278 


i68 
«S8 
348 

J28 
218 
208 


toS 
Weeks 


Reserves  to 

Deposits 

iPer  cent) 

A 

39.60 

/ 

•••••Average  Rcsctvm 

28.80 
38.40 
38.00 
37  60 

\ 

K 

/ 

\ 

Ay 

1^ 

\f 

\ 

1 

\ 

r 

t 

\ 

/ 

0 

A 

,»•..•* 

»*^*m^' 

V 

\ 

K 

j 

/ 

\ 

^.•~»»' 

f 

1 

H 

A 

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26.80 
Weeks 

• 

/ 

V 

> 

/  V. 

-\ 

5            10            15          20           25          30           35           40          45           50       1 

Months 

hn.    1     Feb.  1     M«.  1    Apr.  |    May    |    June  |    July     |  Aug.   |    Sept.  |     Oct.   |    Nov.  |   Dec.  |jan. 

autumn  and  winter  trade,  the  total  supply  of  currency  within 
the  country  must  be  substantially  larger  than  at  other  times 
if  the  needs  of  business  and  trade  are  to  be  adequately  met. 
Accordingly,  we  should  be  able  to  expand  the  total  volume  of 
currency  as  occasion  demands.  Similarly,  it  is  regarded  as 
important  that  when  these  great  seasonal  demands  have  passed 
we  should  be  able  to  contract  the  volume  of  currency.  What 
now  can  be  said  of  the  elasticity  of  our  currency  supply  ? 

The  chart  on  page  499  shows  the  average  amount  of  gold 
coin  and  gold  certificates,  national  bank  notes,  deposit  currency — 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES      499 


Seasonal  Variations  op  Various  Kinds  of  Money  and  of  Deposits 
IN  THE  United  States,  1890-1908 


Gold  Coin 

and  Gold 

Certificates 

(000,000) 

$860.0 


852  S 
845.0 
837  5 
830  o 
822.3 
81S  o 
807.  S 
800.0 


Total 

Money 

(000,000) 

%2,tiO 


3,060 


Months    ^          [2 


•  AvcTatic  Amounts  o(  Gold  Coin  and  Cold  Certificates 
■  Average  Amounts  of  National  Bank  Note* 

^ 

y 

< 

y 

/ 

^^ 

X 

r 

/ 

^ 

^ 



/ 

^^^ 

y^ 

^ 

> 

/ 

/ 

\ 

,y 

/ 

^*'"'^«. 

/ 

N 

^ 

■ 

. 

/ 

^mmmm  Avetage  Amounts  of  Total  Money 

i 

/ 

/ 

\ 

t 

^ 

\ 

\ 

/ 

\ 

\ 

/ 

\ 

1 

\ 

^^ 

\ 

/ 

1 

\ 

^ 

/ 

y 

^^ 

^^ 

/ 

/ 

K.* 

$340 


Amounts  of 

Clearings 

(000,000} 

$4,07S 


t.9JS 

T.77S 
1,700 


^     %     A     "^ 

<        <8        <5       is 


Q     Months 


as  reflected  in  average  clearings,  and  total  money  in  the 
United  States  between  1897  and  1908.  It  will  be  seen  that 
the  gold  supply  does  not  increase  or  decrease  in  accordance 
with  trade  needs,  the  total  supply  depending  upon:  (i)  bullion 
deposits  at  the  United  States  mints  and  assay  offices  (dependent 


500  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

upon  gold  production);  (2)  net  imports  and  exports  of  gold 
in  the  settlement  of  foreign  balances;  and  (3)  receipts  and 
disbursements  of  the  United  States  Treasury,  The  general 
upward  movement  of  the  gold  line  reflects  the  cumulative 
supply  of  this  metal. 

The  national  bank  note  circulation  is  also  very  inelastic. 
The  chart  shows  that  the  total  supply  gradually  increases 
throughout  each  year;  and  that  the  fluctuations  during  the  year 
do  not  coincide  on  the  whole  with  the  varying  requirements 
of  trade.  The  chief  exception  to  this  is  to  be  noted  in  the 
autumn  of  the  year,  when  there  is  typically  a  substantial 
increase.  Kemmerer  explains  this  by  saying,  "Apparently 
banks  intending  to  increase  their  circulation  postpone  doing  so 
until  the  crop-moving  season  approaches.  There  is  no  evidence 
of  contraction,  however,  when  the  crop-moving  demands  are 
over — the  national  bank  note  elasticity  being  (to  use  a  rather 
inelegant  expression)  of  the  chewing  gum  variety. " 

The  reason  for  the  inelasticity  of  bank  note  currency  is 
not  difficult  to  find.  As  already  explained,  bank  notes  can  be 
issued  only  when  secured  by  United  States  government  bonds. 
In  the  years  under  consideration  the  total  supply  of  United 
States  bonds  available  for  use  in  this  connection  was  about 
nine  hundred  millions  and  in  the  latter  years  of  this  period  the 
total  number  thus  being  used  was  in  the  neighborhood  of 
seven  hundred  millions.  A  restricted  supply  of  United  States 
government  bonds  would  therefore  at  best  prevent  any  very 
large  increase  in  the  total  of  bond  secured  currency.  Of  the 
total  outstanding  bonds  not  already  serving  as  security  for 
note  issues,  many  were  not  in  the  market  for  sale  and  hence 
not  available  to  the  banks  in  case  of  need.  This  restricted 
supply  of  government  bonds,  moreover,  tended  to  increase 
their  price  when  demand  for  them  was  active  and  thereby  to 
reduce  the  profits  of  the  banks  in  thus  employing  their  funds. 
Finally,  because  of  the  red  tape  involved  in  the  issue  of  these 
notes,  it  required  about  three  weeks  for  a  bank  located  in  the 
interior  of  the  country  to  put  them  into  circulation.  After 
the  bonds  were  purchased,  it  was  necessary  to  send  them  to 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       501 

the  federal  Treasury  at  Washington  where  the  notes  were 
printed,  bearing  the  name  of  the  bank  which  was  to  issue  them. 
The  notes  were  then  sent  to  the  bank  for  the  signatures  of  the 
officers,  after  which  they  could  be  put  into  the  channels  of  cir- 
culation. While  this  time  element  did  not  prevent  the  banks 
from  making  preparation  for  autumn  monetary  requirements, 
it  nevertheless  did  prevent  a  very  effective  use  of  bank  notes 
in  cases  of  sudden  emergency. 

The  heavy  black  line  at  the  bottom  of  the  chart,  showing 
the  total  currency  supply  by  months  during  the  years  in  ques- 
tion, also '  indicates  no  appreciable  seasonal  elasticity.  The 
reasons  why  the  other  forms  of  currency  besides  gold  and 
national  bank  notes  do  not  possess  the  necessary  elasticity 
may  be  recalled  from  the  discussion  in  chapters  vi  and  vii  above. 

Deposit  currency  alone  exhibits  a  high  degree  of  seasonal 
elasticity.  The  line  showing  the  average  amount  of  clearings 
indicates  a  close  adjustment  of  the  supply  of  deposit  currency 
to  the  varying  requirements  of  trade.  It  expands  when  trade 
needs  increase  and  declines  when  trade  needs  decline.  An 
illustration  of  the  way  in  which  deposit  currency  gets  into  the 
channels  of  circulation  and  is  in  turn  retired  will  serve  to  indicate 
its  automatically  elastic. nature. 

Let  us  assume  that  X,  a  dealer  in  grain,  has  bought  10,000 
bushels  of  wheat  which  is  stored  in  warehouses,  awaiting  move- 
ment to  the  primary  grain  markets.  X  borrows,  say,  $9,000 
from  the  bank,  giving  his  promissory  note  with  the  warehouse 
receipt  as  collateral.  Thus  the  security  back  of  the  deposit 
currency  that  arises  out  of  this  loan  is  the  identical  wheat,  the 
necessity  for  the  marketing  of  which  gave  rise  to  the  increased 
demand  for  currency.  The  needs  of  trade  at  once  call  forth 
and  provide  the  security  for  the  currency  which  is  created. 
As  the  grain  is  sold,  X  receives  funds  which  he  places  on  deposit 
with  his  bank ;  and  when  the  loan  matures  he  pays  it  off  (usually 
and  in  the  main)  by  a  check  against  his  account  made  payable 
to  the  bank.  Thus  when  the  produce  has  been  marketed  and 
the  loan  paid  off,  the  deposit  currency  is  automatically  reduced 
by  the  amount  of  the  loan. 


502  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

While  deposit  currency  thus  readily  responds  to  the  varying 
requirements  of  trade,  there  is  a  limit  to  which  it  can 
be  expanded,  a  limit  imposed  by  the  reserve  requirements. 
The  chart  on  page  498  indicates  that  in  the  autumn  season 
bank  reserves  were  always  down  almost  to  the  minimum  per- 
mitted by  law.  We  shall  shortly  see  that  in  periods  of  acute 
financial  crisis  inadequate  reserves  have  on  many  occasions 
prevented  any  further  expansion  of  bank  loans  and  deposit 
currency.  Ideally  elastic  within  Umits,  there  is  neverthe- 
less a  point  at  which  the  expansibility  of  deposit  currency 
ceases. 

Business  failures  are  most  numerous  in  times  of  seasonal 
monetary  stringency.  It  is  of  interest  to  note  that  the  money 
markets  of  the  autumn  period  are  normally  attended  by  a 
relatively  large  number  of  business  failures.  "As  the  fall 
approaches  and  the  money  market  hardens  in  response  to 
crop-moving  demands,  as  interest  rates  rise,  bank  reserves 
decline,  and  loans  are  curtailed  as  reserves  tend  to  dechne 
and  increased  margins  are  called  for,  th^  strain  on  the  weakest 
business  concerns  is  liable  to  become  more  tense.  While  of 
course  it  would  be  rash  to  say  that  the  tightened  money  market 
in  the  fall  is  the  cause  of  the  larger  number  of  failures  at  this 
period,  it  seems  reasonable  to  expect  that  the  strained  money 
market  at  this,  time  would  tend  to  push  over  many  concerns 
which  were  already  near  the  verge  of  failure.  I  know  of  no 
other  explanation  of  the  large  number  of  failures  during  October 
and  November."' 

The  federal  Treasury  has  borne  an  interesting  relation  to  the 
money  market.  The  supply  of  funds  for  the  needs  of  business  is 
affected  to  some  extent  by  the  flow  of  specie  to  and  from  the 
federal  Treasury.  The  Treasury  Department  normally  receives 
funds  largely  from  taxes.  Some  of  the  sources  of  taxation 
provide  a  fairly  regular  flow  of  income,  but  others  a  very 
irregular  one.  Similarly,  some  of  the  government's  disburse- 
ments constitute  a  fairly  regular  outflow,  while  others  are 

'  E.  W.  Kemmerer,  op.  cit.,  p.  323. 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       503 

intermittent.  Accordingly,  there  are  times  when  the  supply 
of  funds  in  the  Treasury  is  large,  and  there  are  times  when  it  is 
small.  There  have  been  occasions,  also,  when,  owing  to  the 
lack  of  a  government  budget,  the  total  receipts  have  been 
considerably  in  excess  of  total  disbursements.  In  consequence, 
the  disposition  of  government  funds  has  always  been  a  prob- 
lem of  no  little  importance.  There  follows  a  brief  summary  of 
the  historical  relations  between  the  United  States  Treasury 
and  the  banks  of  the  country: 

1.  From  1789  to  1796  the  federal  funds  were  mainly  left 
in  the  hands  of  the  collecting  and  disbursing  officers,  for  the 
reason  that  there  was  no  specific  place  for  the  custody  of  pubhc 
money. 

2.  Between  1796  and  181 1  public  funds  were  kept  mainly 
in  the  First  Bank  of  the  United  States,  which  was  the  fiscal 
agent  of  the  United  States  government. 

3.  Between  181 1  and  1816,  when  the  Second  Bank  of  the 
United  States  was  chartered,  Treasury  funds  were  kept  mainly 
in  state  banks. 

4.  Between  1816  and  1833  the  Second  Bank  of  the  United 
States  was  employed,  although  the  state  banks  were  still  used 
to  some  extent. 

5.  Between  1833  and  1846  state  banks  were  exclusively 
used.  Charges  of  favoritism  in  the  selection  of  state  banks 
and  the  growing  opposition  to  close  relations  between  the 
banks  and  the  Treasury  led  to  the  adoption  of  the  "inde- 
pendent" Treasury  in  1846. 

6.  From  1846  to  1863  public  money  was  kept  entirely  in 
the  federal  Treasury  and  the  nine  sub-treasuries  which  were 
located  in  the  larger  financial  centers  of  the  country. 

7.  With  the  establishment  of  the  national  banking  system 
in  1863  the  Secretary  of  the  Treasury  was  authorized  to  select 
c-ertain  national  banks  as  depositary  institutions  for  public 
money.  For  a  time  these  banks  were  required  to  keep  a  special 
reserve  against  Treasury  funds,  although  this  practice  was 
finally  abandoned.  Under  the  national  banking  system  the 
amount  of  public  money  deposited  with  the  banks  steadily 


S04         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

increased  in  volume  until  at  times  there  was  only  a  very  small 
working  balance  in  the  Treasury.^ 

The  Treasury  has  sometimes  endeavored  to  relieve  seasonal 
stringency.  The  seasonal  strain  upon  bank  reserves  became  so 
great  in  the  early  autumn  of  191 2  that  Secretary  McVeagh 
developed  a  plan  for  relieving,  as  far  as  possible,  the  strain 
upon  the  national  banks.  The  plan  consisted  of  placing 
Treasury  funds  in  banks  in  advance  of  any  importation  of 
gold  that  might  be  arranged  for;  such  funds  to  be  available  as 
reserve  money  for  the  banks  just  as  soon  as  arrangements  had 
been  completed  for  the  import  of  specie.  By  making  it  possible 
for  the  banks  to  have  the  immediate  use  of  such  funds,  the 
importation  of  specie  was  encouraged. 

A  still  better  plan  was  elaborated  in  the  autumn  of  1913. 
To  quote  the  words  of  the  Secretary  of  the  Treasury:  "Toward 
the  latter  part  of  July  symptoms  of  uneasiness  began  to  appear. 
There  was  much  talk  about  the  difhculty  of  moving  the  fall 
crops,  and  the  annual  apprehension  on  this  score  began  to 

stalk  about  the  country  with  more  than  usual  vigor 

Conditions  were  again  becoming  acute  when  the  Secretary 
determined  to  deposit  from  twenty-five  to  fifty  millions  of 
dollars  of  government  funds  in  the  national  banks  in  those 
parts  of  the  country  where  the  necessity  for  funds  to  move 
crops  existed."  These  deposits  were  made  on  three  different 
sorts  of  securities:  (i)  United  States  bonds  at  par  (at  least  10 
per  cent  were  required  to  be  so  secured);  (2)  miscellaneous 
bonds  approved  by  the  Secretary,  at  75  per  cent  of  their  market 
value;  (3)  approved  prime  commercial  or  business  paper 
indorsed  by  the  bank,  at  65  per  cent  of  its  face  value  (raised  in 
1914  to  75  per  cent). 

In  the  year  1913  a  total  of  $37,386,000  was  deposited  in 

the  banks  of  the  cotton-growing  states.    The  somewhat  smaller 

amount  deposited  in  19 14  is  to  be  explained,  in  the  main,  by 

the  issue  of  emergency  currency  at  the  outbreak  of  the  European 

war,  a  considerable  portion  of  which  went  directly  or  indirectly 

into  the  agricultural  states. 

»  For  the  relation  of  the  Treasury  to  the  banks  since  the  establishment 
of  the  Federal  Reserve  System,  see  pp.  614-16. 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       505 

Treasury  aid  in  meeting  seasonal  demands  for  currency  is, 
however,  confessedly  a  poor  expedient.  It  does  not  give  the 
requisite  expansibility  in  the  total  quantity  of  funds;  there  is 
never  any  assurance  that  the  Treasury  will  have  on  hand  funds 
of  sufficient  volume  to  fill  the  hiatus  in  the  supply  of  bank 
currency. 

n.    CYCLICAL  VARIATIONS  IN  THE  DEMAND 

FOR  FUNDS 

The  ebb  and  flow  of  business  activity  that  characterizes 
the  business  cycle  may  most  easily  be  shown  by  reference  to 
the  financial  history  of  the  United  States.  There  follows  a 
summary  statement  of  the  cycles  in  American  financial  history. 
The  brief  accompanying  comments  are  not  to  be  regarded  as 
explanations  of  the  phenomena  in  question.^  They  are  intended 
merely  to  recount  the  outstanding  features  in  the  ebb  and 
flow  of  business  activity. 

While  there  were  some  early  disturbances  of  importance, 
it  is  generally  stated  that  the  first  panic  in  the  United  States 
occurred  in  August,  1814.  It  was  a  direct  result  of  the  capture 
of  Washington  by  the  British,  though  the  disruption  of  trade 
and  the  exigencies  of  war  finance  were  contributing  factors. 
This  panic,  however,  was  not  the  outgrowth  of  ordinary  com- 
mercial and  financial  conditions;   it  was  special  in  its  nature. 

The  first  genuine  crisis  in  the  United  States  occurred  in 
1819.'  It  may  be  superficially  stated  that  it  was  an  outgrowth 
of  the  abnormal  expansion  of  manufacturing  industries  occa- 
sioned by  the  embargo  and  the  War  of  181 2,  and  by  the  neces- 
sary readjustments  that  follow  a  period  of  paper  currency. 
Not  until  late  in  1821  did  commerce. and  industry  begin  to 
revive. 

There  followed  a  period  of  great  prosperity  and  rapid 
territorial  and  business  expansion,  which  continued  with  but 
slight  interruptions  until  1837.  In  1824  there  was  an  industrial 
boom,  and  m  1826  there  was  a  reaction,  due,  in  part,  to  the 

'  For  an  analysis  of  the  causes  of  business  cycles  see  pp.  512-18. 

*  The  first  in  American  history  was  the  one  which  occurred  during  the 
Confederation  period,  in  1786. 


5o6  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

European  crisis  of  December,  1825;  but  these  were  merely 
temporary  deviations  from  an  otherwise  fairly  continuous 
expansion. 

The  crisis  culminating  in  the  disastrous  panic  of  May,  1837, 
is  associated  with  an  undue  extension  of  banking  and  credit, 
an  over-provision  of  public  roads,  canals,  and  railways,  and 
excessive  speculation  in  western  lands.  Recovery  from  the 
panic  was  very  slow;  indeed,  it  was  more  than  a  year  before 
the  banks  resumed  specie  payments.  A  period  of  depression 
followed  until  the  summer  of  1843,  a  premature  revival  in 
1838  and  1839  resulting  in  a  multitude  of  failures. 

A  general  revival  of  trade  began  in  the  autumn  of  1843  and 
continued  without  much  interruption  until  1857.  The  Euro- 
pean crisis  of  1847  exercised  little  influence  here,  owing  to  good 
crops  and  heavy  exportations.  There  was,  however,  a  minor 
crisis  in  1848,  occasioned  in  the  main  by  the  Mexican  War. 
The  period  of  rapid  expansion  came  to  a  head  in  the  very 
sudden  and  sharp  crisis  of  August,  1857.  While  the  financial 
disturbance  appears  to  have  been  more  acute  than  in  1837, 
industry  and  commerce  were  much  less  seriously  affected,  and  in 
consequence  the  succeeding  period  of  depression  was  less 
universal  in  its  effects.  The  depression  reached  its  worst  phase 
in  1859.  Conditions  were  rapidly  on  the  mend  in  i860,  but  the 
outbreak  of  war  in  1861  so  disarranged  the  financial  and  indus- 
trial affairs  of  the  nation  that  the  return  of  prosperity  was 
postponed  for  a  half-dozen  years.  There  was  a  great  crisis  in 
England  in  1866  which  the  war,  no  doubt,  enabled  us  to  escape. 

Following  the  Civil  War  we  entered  upon  a  new  era  of 
industrial  expansion.  Wide  areas  of  agricultural  lands  were 
opened  up,  immigration  was  heavy,  railroads  were  built  on  a 
scale  hitherto  undreamed  of — built  far  ahead  of  settlements 
and  the  demands  of  trade.  It  was  a  period  also  of  wild  specu- 
lation, dishonesty,  and  extravagance.  The  great  crisis  of  1873 
affected  practically  every  operation  of  commerce  and  finance, 
and  shook  the  credit  structure  to  its  very  foundations.  The 
succeeding  depression  was  unprecedented  in  severity  and 
duration,  continuing  in  most  branches  of  industry  until  the 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       507 

end  of  1878,  and  in  some  lines  until  1879.  The  largest  number 
of  failures  occurred  in  the  year  1878. 

Prosperity  returned  with  bountiful  harvests  and  the  resump- 
tion of  specie  payments  in  1879.  A  period  of  world-wide 
prosperity  was  marked  in  the  United  States  by  another  era  of 
enormous  railroad  building,  industrial  expansion,  and  extrava- 
gant living,  which  ended  in  the  minor  crisis  of  May,  1884.  The 
downward  movement  continued  until  1886;  after  the  recovery 
there  was  a  season  of  moderate  activity  until  1890.  The 
great  crisis  in  Europe,  attending  the  failure  of  the  famous 
Enghsh  banking  house  of  Baring  Brothers,  near  the  end  of  the 
year  1890,  was  felt  acutely  in  the  United  States,  though  we 
escaped  a  complete  breakdown,  the  enormous  crops  and  heavy 
exports  of  1891  tiding  us  over  the  threatening  situation  for 
another  year  or  two.  But  in  May,  1893,  we  again  went  to  the 
wall  with  a  panic  which  in  many  respects  was  even  more  severe 
than  that  of  1873.  This  crisis,  however,  was  complicated  by 
the  unstable  monetary  standard  of  the  time;  and  by  many 
it  has  been  called  a  monetary  rather  than  a  financial  crisis. 
It  was  doubtless  a  result  of  combined  influences.  The  depres- 
sion continued  until  1896. 

Along  with  the  entire  commercial  world,  in  1897  we  entered 
upon  another  great  period  of  expansion,  which  was  accelerated 
after  the  Spanish  War.  It  continued  with  but  minor  reactions 
until  the  autumn  of  1907.  The  crisis  which  ended  in  the 
panic  of  October,  1907,  was  accompanied  by  all  the  usual 
manifestations  of  such  periods,  and  the  depression  which 
followed  continued  for  more  than  a  year.  The  succeeding  years 
were  marked  by  business  and  banking  uncertainty,  consequent 
upon  extensive  legislative  experiments,  Mexican  troubles,  and 
the  European  war.  The  outbreak  of  war  in  Europe  occasioned 
a  severe  financial  crisis  and  near-panic  in  the  United  States, 
fortunately  tided  ove-  successfully  by  the  use  of  emergency 
currency.  Beginning  with  the  autunm  of  1915  we  again 
entered  upon  a  period  of  great  business  expansion,  superinduced 
by  European  demands  for  American  goods.^ 

^  For  a  consideration  of  the  subsequent  history  of  this  boom  sec  chap, 
xxviii. 


5o8  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  panic  stage  of  the  cycle  has  attracted  most  attention. 
Of  the  various  stages  which  comprise  the  complete  round  of 
the  business  cycle,  the  panic  stage — which  is  marked  by  the 
breakdown  of  the  financial  mechanism  and  the  suspension  of 
specie  payments — has  of  course  attracted  the  greatest  attention. 
Indeed,  until  comparatively  recent  times  panics  have  been 
treated  by  many  writers  as  more  or  less  independent  phenomena, 
rather  than  as  merely  the  culmination  of  a  series  of  economic 
and  financial  developments — than  as  but  a  single  stage  in  a 
general  process.  Thus  they  are  often  referred  to  as  sudden 
earthquakes  or  volcanic  eruptions  which  appear  when  least 
expected  and  profoundly  disrupt  the  normal  economic  structure. 
It  is  not  surprising,  perhaps,  that  writers  should  have  stressed 
the  phenomenon  of  the  panic  to  the  exclusion  of  other  phases  of 
the  business  cycle,  for  the  outstanding  features  attending  the 
financial  panic  are  sensational  in  a  high  degree,  and  its  social 
consequences  are  appalling. 

In  brief,  a  financial  panic  involves  a  practically  complete 
breakdown  of  the  delicate  credit  structure  on  which  virtually 
the  entire  economic  organization  has  been  erected.  On  the 
business  and  commercial  side,  confidence,  which  lies  at  the 
basis  of  all  lending  or  credit  operations,  is  temporarily  shattered; 
and  on  the  banking  side,  the  slender  margin  of  specie  reserves, 
on  which  has  been  reared  the  huge  superstructure  of  deposit 
currency,  fails  to  perform  its  function,  with  the  result  that  the 
credit  system  breaks  down  and  deposits  are  no  longer  redeemable 
in  specie.  And  to  make  the  immediate  situation  worse,  the 
banks  refuse  to  part  with  any  specie;  all  of  them  are  temporarily 
insolvent.  The  result  is  a  currency  famine  for  the  ordinary 
needs  of  trade,  a  famine  which  can  only  in  part  be  overcome 
by  a  resort  to  substitute  means  of  payment  !n  the  form  of 
clearing-house  loan  certificates,  etc.* 

The  credit  and  business  structure  is  extremely  delicate.  The 
evolution  of  our  credit  system  has  resulted  in  a  very  close 
interdependency  within  the  different  divisions  of  industry  and  in 
the  industrial  system  as  a  whole.    For  instance,  producers  of 

»See  pp.  537-39. 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       509 

raw  materials  sell  goods  on  credit  to  manufacturers;  manu- 
facturers sell  goods  on  credit  to  wholesalers  and  jobbers;  and 
these  in  turn  sell  goods  on  credit  to  the  retailers,  who  in  their 
turn  characteristically  sell  on  open  or  charge  accounts  to  the 
ultimate  consumers.  Nor  is  it  merely  the  dififerent  steps  in 
the  productive  and  distributive  process  within  a  given  industry 
that  are  closely  related;  the  different  divisions  of  industry  are 
all  interdependent.  For  example,  a  decline  in  the  demand  for 
automobiles  is  shortly  manifested  in  a  reduced  demand  for 
steel,  and  for  rubber  and  cotton  used  in  making  tires;  while 
the  laying  off  of  workmen  all  along  the  line  results  in  a  slackening 
demand  for  the  products  of  every  industry.  And  as  we  have 
seen  in  preceding  chapters,  practically  all  of  these  various 
business  concerns  are  in  turn  dependent  upon  the  banks  for 
at  least  a  portion  of  the  funds  which  they  require.  In  con- 
sequence a  breakdown  of  the  complicated  credit  structure  at  any 
point  involves  a  wholesale  wreckage  of  established  relationships. 
The  failure  of  A  to  pay  B  makes  it  impossible  for  B  to  pay  C,  for 
C  to  pay  D,  for  D  to  pay  E,  etc.  Just  as  an  entire  row  of 
dominoes  is  toppled  down  by  tipping  over  the  one  at  the 
beginning  of  the  row,  so  also  when  credit  relations  are  disrupted 
the  whole  chain  of  business  establishments  is  involved  in 
eommon  loss  or  failure. 

One  of  the  outstanding  features  of  the  financial  crisis, 
therefore,  is  wholesale  failures  of  business  concerns,  many  of 
which  are  forced  into  insolvency  only  because  of  their  depen- 
dency upon  other  institutions  which  are  unfortunately  caught  in 
the  financial  vortex.  In  the  case  of  a  major  collapse  literally 
thousands  of  business  concerns,  some  of  them  of  the  highest 
standing,  are  involved  in  ruin.  Many  large  financia  1  institutions 
are  among  them,  although  it  should  be  noted  that  the  temporary 
insolvency  of  the  banks,  of  which  we  have  spoken,  does  not 
usually  denote  a  permanent  inability  to  pay  depositors  in  full. 
After  a  period  of  Uquidation  has  elapsed,  the  great  majority  of 
banks  are  enabled  to  resume  their  normal  operations. 

The  period  of  depression  involves  enormous  economic  losses. 
Less  striking,  perhaps,  but  of  greater  social  import,  is  the 


510  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

grave  business  depression  that  follows  in  the.  wake  of  a  financial 
panic,  involving  an  enormous  volume  of  unemployment  and 
acute  suffering  for  millions  of  people.  We  may  conceive  of 
industrial  society  as  a  huge  complex  machine  engaged  in  the 
process  of  turning  out  commodities  and  services  in  the  form  of 
necessities,  conveniences,  and  luxuries.  At  the  height  of  the 
period  of  business  prosperity  this  vast  industrial  machine 
may  be  regarded  as  running  at  maximum  capacity,  with  virtu- 
ally all  of  the  industrial  equipment  and  all  of  the  labor-power 
of  the  nation  fully  employed  and  with  returns  in  the  form  of 
profits  and  wages  at  a  maximum  level.  Immediately  following 
a  panic,  on  the  other  hand,  this  machine  is  thrown  completely 
out  of  gear.  It  is  able  to  run,  often  for  a  period  of  several  years, 
at  from  perhaps  50  to  60  per  cent  capacity,  with  business 
profits  at  a  minimum;  with  wages  at  a  low  level;  and  with 
attendant  suffering  and  misery  for  the  unemployed  millions. 
The  results  of  a  panic  may  be  indicated  by  the  following 
statement  of  conditions  that  prevailed  in  1908,  shortly  after 
the  panic  of  October,  1907.  For  the  first  two  weeks  of  January, 
1908,  gross  earnings  of  the  railroads  were  about  13  per  cent 
less  than  in  1907.  Where  in  September,  1907,  there  were  not 
enough  railroad  cars  with  which  to  vmove  the  traffic  of  the 
country,  there  were  approximately  320,000  freight  cars  and 
8,000  locomotives  standing  idle,  representing  an  investment  of 
more  than  $400,000,000;  and  there  were  also  more  than  30,000 
unemployed  trainmen.  The  net  earnings  of  the  United  States 
Steel  Corporation  declined  from  $17,052,211  in  October,  to 
$10,467,253  in  November,  and  to  $5,034,531  in  December — a 
decline  of  over  70  per  cent.  The  Bradstreet  commercial  agency 
report  informs  us  that  "it  is  safe  to  say  that  estimates  of 
shrinkages  of  30  to  50  per  cent  in  sales  and  general  turnover 
are  not  unreasonable.  Iron  output  will  probably  be  50  per 
cent  below  a  year  ago.  Shoe  shipments  are  about  30  per 
cent  below  January,  1907.  Lumber  and  all  kinds  of  build- 
ing material  are  very  quiet  the  country  over.  There  are 
widespread  reports  of  unemployment  in  all  sections  of  the 
country. " 


•     COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       511 

There  have  been  numerous  explanations  of  these  financial 
cataclysms.  The  phenomenon  of  financial  crises,  or  panics, 
arose  with  the  development  of  the  modern  credit  and  banking 
structure  of  society.  And  since  this  credit  society  of  ours  is 
now  nearly  two  centuries  old,'  there  has  naturally  been  a 
great  deal  of  discussion  on  the  subject  of  nnancial  panics. 
This  is  not  the  place  to  enter  upon  an  analysis  of  the  many 
causes  that  have  been  suggested.  It  is  sufficient  to  note  that 
the  periodicity  of  panics  early  attracted  attention,  and  this 
naturally  led  to  a  study  of  the  influences  that  might  account 
for  their  more  or  less  regular  recurrence.  One  of  the  most 
interesting  of  the  explanations  of  the  phenomenon  is  the  famous 
sun-spot  theory,  elaborated  by  Professor  Jevons,  who  gained  a 
reputation  both  as  an  astronomer  and  as  an  economist.  At 
first  blush  the  sun-spot  explanation  of  panics  appears  extremely 
far-fetched.  Jevons  reasoned,  however,  that  changes  in  indus- 
trial activity  are  a  reflection  of  changes  in  weather  conditions, 
the  argument  being  that  a  poor  crop  year  would  result  in  a 
lessened  demand  for  commodities  at  the  retail  stores  in  all  the 
rural  communities  and  this  in  turn  would  be  reflected  throughout 
the  entire  industrial  system  in  declining  demand  and  consequent 
industrial  stagnation  leading  to  business  failures  and  financial 
collapse.  The  sun-spots  were  invoked  as  an  explanation  of 
the  periodicity  of  weather  conditions,  the  idea  being  that  the 
appearance  of  sun-spots  was  reflected  in  untoward  weather. 
This  theory,  however,  has  been  entirely  discredited  by  virtue 
of  the  fact  that  there  is  no  close  correlation  between  observed 
sun-spots  and  weather  conditions. 

The  most  comprehensive  study  of  the  problem,  however,  is 
that  made  by  Professor  Mitchell  and  pubUshed  in  1910  in  a 
large  quarto  volume  entitled  Business  Cycles.  In  evolving 
his  theory  of  business  cycles  Professor  Mitchell  first  made  a 
statistical  study  of  all  of  the  financial,  commercial,  and  economic 
data  bearing  on  the  ebb  and  flow  of  business  activity  in  the 

'  Historians,  however,  record  similar  phenomena  in  connection  with 
the  credit  and  banking  organization  of  early  Italian  cities  and  of  certain  of 
the  commercial  nations  of  antiquity. 


512         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

four  greatest  commercial  and  credit  nations  of  the  world  during 
four  complete  cycles,  from  1873  through  1907.  On  the  basis 
of  his  study  of  the  concrete  facts  of  the  situation,  Professor 
Mitchell  has  worked  out  a  statement  of  the  rhythm  of  business 
activity,  which  shifts  the  emphasis  from  a  study  of  the  financial 
panic,  which  is  but  one  phase  of  the  business  cycle,  to  a  study 
of  the  cycle  as  a  whole  with  its  various  phases  of  depression, 
prosperity,  crisis,  and  panic;  and  he  shows  conclusively,  in  my 
judgment,  that  our  modern  industrial  and  financial  system  is 
controlled  by  forces  which  are  always  at  work  to  produce  change, 
sometimes  gradually,  sometimes  abruptly,  but  always  cumu- 
lative change — change,  however,  which  moves  with  a  certain 
precision,  and  which  gradually  passes  from  one  rather  clearly 
defined  stage  to  another.*  We  cannot  do  better  than  to  give 
at  this  place  Mitchell's  own  summary  statement  of  the  rhythm 
of  business  activity.* 

With  whatever  phase  of  the  business  cycle  analysis  begins,  it 
must  take  for  granted  the  conditions  brought  about  by  the  preceding 
phase,  postponing  explanation  of  these  assumptions  until  it  has 
worked  around  the  cycle  and  come  again  to  its  starting-point. 

A  revival  of  activity,  then,  starts  with  a  legacy  from  depression: 
a  level  of  prices  low  in  comparison  with  the  prices  of  prosperity, 
drastic  reductions  in  the  costs  of  doing  business,  narrow  margins  of 
profit,  Hberal  bank  reserves,  a  conservative  policy  in  capitalizing 
business  enterprises  and  in  granting  credits,  moderate  stocks  of 
goods,  and  cautious  buying. 

Such  conditions  are  accompanied  by  an  expansion  in  the  physical 
volume  of  trade.  Though  slow  at  first,  this  expansion  is  cumulative. 
In  time  an  increase  in  the  amount  of  business  which  grows  more 
rapid  as  it  proceeds  will  turn  dulness  into  activity.  Left  to  itself 
this  transformation  is  effected  by  slow  degrees;  but  it  is  often  hastened 
by  some  propitious  event,  such  as  exceptionally  profitable  harvests 
or  heavy  purchases  of  supplies  by  the  government. 

'  A  more  recent  statistical  study  of  the  phenomena  of  business  cycles 
is  that  made  by  Professor  Warren  M.  Persons.  See  reference  at  end  of  this 
chapter. 

*  Wesley  C.  Mitchell,  Business  Cycles,  pp.  571-79.  (Copyright  by 
the  author,  1913.    Published  by  the  University  of  California  Press.) 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       513 

A  partial  revival  of  industry  soon  spreads  to  all  parts  of  the 
business  field.  For  the  active  enterprises  must  buy  materials  and 
current  supplies  from  other  enterprises,  the  latter  from  still  others, 
etc.  Meanwhile  all  enterprises  which  become  busier  employ  more 
labor,  use  more  borrowed  money,  and  make  higher  profits.  There 
results  an  increase  in  family  incomes  and  an  expansion  of  consumirrs, 
demands,  which  likewise  spreads  out  in  ever-widening  circles.  Shop- 
keepers pass  on  larger  orders  to  wholesale  merchants,  manufacturers, 
importers,  and  producers  of  raw  materials.  All  these  enterprises 
increase  the  sums  they  pay  to  employees,  lenders,  and  proprietors. 
In  time  the  expansion  of  orders  reaches  back  to  the  enterprises  from 
which  the  initial  impetus  was  received,  and  then  the  whole  compU- 
cated  series  of  reactions  begins  afresh  at  a  higher  pitch  of  intensity. 
All  this  while  the  revival  of  activity  is  instilling  a  feeling  of  optimism 
among  business  men. 

The  cumulative  expansion  of  the  physical  volume  of  trade  stops 
the  fall  in  prices  and  starts  a  rise.  For  when  enterprises  have  in 
sight  as  much  business  as  they  can  handle  with  existing  facilities, 
they  stand  out  for  higher  prices  on  additional  orders.  This  policy 
prevails  because  additional  orders  can  be  executed  only  by  breaking 
in  new  hands,  starting  new  machinery,  or  buying  new  equipment, 
The  expectation  of  its  coming  hastens  the  advance.  Buyers  are 
anxious  to  secure  large  supplies  while  the  quotations  continue 
low,  and  the  first  signs  of  an  upward  trend  bring  out  a  rush  of 
orders. 

The  rise  of  prices  spreads  rapidly,  for  every  advance  puts  pressure 
on  someone  to  recoup  himself  by  advancing  the  prices  of  what  he  has 
to  sell.  The  resulting  changes  in  price  are  far  from  even:  retail 
prices  lag  behind  wholesale  and  the  price  of  finished  products  behind 
the  price  of  raw  materials.  Among  the  last  mentioned  the  prices 
of  mineral  products  reflect  changed  business  conditions  more  regu- 
larly than  do  the  prices  of  forest  and  farm  products.  Wages  rise 
more  promptly  but  in  less  degree  than  wholesale  prices;  interest 
rates  on  long  loans  always  move  sluggishly  in  the  earlier  stages  of 
revival,  while  the  prices  of  stocks  both  precede  and  exceed  commodity 
prices  on  the  rise. 

In  the  great  majority  of  enterprises  larger  profits  result  from 
these  divergent  fluctuations,  coupled  with  the  greater  physical 
volume  of  sales.  For  while  the  prices  of  raw  materials  and  of  bank 
loans  often  rise  faster  than   seUing   prices,  the  prices  of  labor  lag 


Sid  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

behind,  and  the  prices  making  up  supplementary  costs  are  mainly 
stereotyped  by  old  agreements. 

The  increase  of  profits,  under  the  spell  of  optimism,  leads  to  a 
marked  expansion  of  investments.  The  heavy  orders  for  machinery, 
the  large  contracts  for  new  construction,  etc.,  which  result,  swell 
still  further  the  physical  volume  of  business  and  render  yet  stronger 
the  forces  which  are  driving  prices  upward. 

Indeed,  the  salient  characteristic  of  this  phase  of  the  business 
cycle  is  the  cumulative  working  of  the  various  processes  which  are 
converting  a  revival  of  trade  into  intense  prosperity.  Not  only 
does  every  increase  in  the  volume  of  trade  cause  other  increases, 
every  convert  to  optimism  make  new  converts,  and  every  advance 
in  price  furnish  an  incentive  for  new  advances;  but  the  growth  of 
trade  also  helps  to  spread  optimism  and  to  raise  prices,  while  opti- 
mism and  rising  prices  support  each  other.  Finally,  the  changes  going 
forward  swell  profits  and  encourage  investments,  while  high  profits 
and  heavy  investments  react  by  augmenting  trade,  justifying  opti- 
mism, and  raising  prices. 

While  the  processes  just  sketched  work  cumulatively  for  a  time 
to  enhance  prosperity,  they  also  cause  a  slow  accumulation  of  stresses 
within  the  balanced  system'  of  business — stresses  which  ultimately 
undermine  the  conditions  upon  which  prosperity  rests. 

Among  these  is  the  gradual  increase  in  the  cost  of  doing  business. 
The  decline  in  supplementary  costs  per  unit  ceases  when  enterprises 
have  secured  all  the  business  they  can  handle  with  their  standard 
equipment,  and  a  slow  increase  in  these  costs  begins  when  the  expi- 
ration of  old  contracts  makes  necessary  renewals  at  higher  rates. 
Meanwhile  prime  costs  rise  at  a  relatively  rapid  rate.  The  price  of 
labor  rises  both  because  of  an  advance  in  nominal  wages  and  because 
of  higher  rates  for  overtime.  More  serious  is  a  decline  in  the  efii- 
ciency  of  labor,  because  of  the  employment  of  undesirables  and 
because  crews  cannot  be  driven  at  top  speed  when  jobs  are  more 
numerous  than  men.  The  prices  of  raw  material  rise  faster  on  the 
average  than  the  selling  prices  of  products.  Finally,  numerous 
small  wastes  creep  up  when  managers  are  hurried  by  press  of  orders. 

A  second  stress  is  the  accumulating  tension  of  investment  and 
money  markets.  The  supply  of  funds  available  at  the  old  rates 
fails  to  keep  pace  with  the  swelling  demand.  It  becomes  difficult  to 
negotiate  new  issues  of  securities  except  on  onerous  terms,  and  men 
of  affairs  complain  of  the  "scarcity  of  capital."    Nor  does  the 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       515 

supply  of  bank  loans,  limited  by  reserves,  grow  fast  enough  to  keep 
up  with  the  demand.  Active  trade  keeps  such  an  amount  of  money 
in  circulation  that  the  cash  left  in  the  banks  increases  rather  slowly. 
On  the  other  hand,  the  demand  for  loans  grows,  not  only  with  the 
physical  volume  of  trade,  but  also  with  the  rise  of  prices,  and  with 
the  desire  of  men  of  affairs  to  use  their  own  funds  for  controlling  as 
many  businesses  as  possible. 

Tension  in  the  bond  and  money  markets  is  unfavorable  to  the 
continuance  of  prosperity,  not  only  because  high  rates  of  interest 
reduce  the  prospective  margins  of  profit,  but  also  because  they  check 
the  expansion  of  the  volume  of  trade  out  of  which  prosperity  develops. 
Many  projected  ventures  are  relinquished  because  borrowers  con- 
clude that  interest  would  absorb  too  much  of  their  profits. 

The  group  producing  industrial  equipment  suffers  especially. 
In  the  earlier  stages  of  prosp)erity  this  group  enjoys  exceptional 
activity.  But  when  the  market  for  bonds  becomes  stringent  and 
the  cost  of  construction  high,  business  enterprises  defer  the  execution 
of  plans  for  extending  old  or  erecting  new  plants.  As  a  result,  con- 
tracts for  this  kind  of  work  become  less  numerous  as  the  climax 
of  prosperity  approaches.  Then  the  steel  mills,  foundries-,  machine 
factories,  lumber  mUls,  construction  companies,  etc.,  find  their 
orders  for  future  delivery  falling  off. 

The  larger  the  structure  of  prosperity,  the  more  severe  become 
these  internal  stresses.  The  only  effective  means  of  preventing 
disaster  while  continuing  to  build  is  to  raise  selling  prices  time  after 
time  high  enough  to  offset  the  encroachment  of  costs  upon  profits 
and  to  keep  investors  willing  to  contract  for  fresh  industrial  equipment. 

But  it  is  impossible  to  keep  selling  prices  rising  for  an  indefinite 
time.  In  default  of  other  checks  the  inadequacy  of  cash  reserves 
would  ultimately  compel  the  banks  to  refuse  a  further  expansion  of 
loans  on  any  terms.  But  before  this  stage  has  been  reached  the  rise 
of  prices  is  stopped  by  the  consequences  of  its  own  inevitable  inequali- 
ties. These  become  more  glaring  the  higher  the  general  level  is 
forced;  after  a  time  they  threaten  serious  reductions  of  profits  to 
certain  business  enterprises,  and  the  troubles  of  these  victims  dissolve 
that  confidence  in  the  security  of  credits  with  which  the  whole 
towering  structure  of  prosperity  has  been  cemented. 

In  certain  lines  in  which  selling  prices  are  stereotyped  by  law. 
by  contracts  for  long  terms,  by  custom,  or  by  business  policy,  selling 
prices  cannot  be  raised  to  prevent  a  reduction  of  profits.    In  other 


Sl6  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

lines  prices  are  always  subject  to  the  incalculable  chances  of  the 
harvests.  In  some  lines  the  recent  construction  of  new  equipment 
has  increased  the  capacity  for  production  faster  than  the  demand 
for  wares  has  expanded  under  the  repressing  influence  of  high  prices. 
The  unwiUingness  of  investors  to  let  fresh  contracts  threatens  loss 
not  only  to  the  contracting  firms  but  to  the  enterprises  from  which 
they  buy  materials.  Finally,  the  success  of  some  enterprises  in 
raising  prices  fast  enough  to  defend  their  profits  aggravates  the 
difficulties  of  the  men  who  are  in  trouble. 

As  prosperity  approaches  its  height,  then,  a  sharp  contrast  develops 
between  the  business  prospects  of  different  enterprises.  Many  are 
making  more  money  than  at  any  previous  stage  in  the  business 
cycle.  But  an  important  minority  faces  the  prospect  of  declining 
profits.  The  more  intense  prosperity  becomes,  the  larger  grows 
this  threatened  group.  In  time  these  conditions  bred  by  prosperity 
will  force  radical  readjustment. 

Such  a  decline  of  profits  threatens  consequences  worse  than  the 
failure  to  realize  expected  dividends;  for  it  arouses  doubt  about  the 
future  of  outstanding  credits.  Business  credit  is  based  primarily 
upon  the  capitalized  value  of  present  and  prospective  profits,  and  the 
volume  of  credits  outstanding  at  the  zenith  of  prosperity  is  adjusted 
to  the  great  expectations  which  prevail  when  affairs  are  optimistic. 
The  rise  of  interest  rates  has  already  narrowed  the  margins  of  security 
behind  credits  by  reducing  the  capitalized  value  of  given  profits. 
When  profits  begin  to  waver,  creditors  begin  to  fear  lest  the  shrinkage 
in  the  market  rating  of  business  enterprises  which  owe  them  money 
will  leave  no  adequate  security  for  repayment.  Hence  they  refuse 
renewals  of  old  loans  to  enterprises  which  cannot  stave  off  a  decline 
in  profits  and  press  for  settlement  of  outstanding  accounts. 

Thus  prosperity  ultimately  brings  on  conditions  which  start  a 
liquidation  of  the  huge  credits  which  it  has  piled  up.  And  in  the 
course  of  this  liquidation  prosp)erity  merges  into  crisis.  Once  begun, 
the  process  of  liquidation  extends  rapidly,  partly  because  most 
enterprises  called  upon  to  settle  put  similar  pressure  on  their  own 
debtors,  and  partly  because  news  presently  leaks  out  and  other 
creditors  take  alarm. 

While  this  financial  readjustment  is  under  way  the  problem  of 
making  profits  is  subordinated  to  the  more  vital  problem  of  main- 
taining solvency.  Business  managers  nurse  their  financial  resources 
rather  than  push  their  sales.    In  consequence  the  volume  of  new 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       517 

orders  falls  off  rapidly.  The  prospect  of  profits  is  dimmed.  Expan- 
sion gives  place  to  contraction.  Discount  rates  rise  higher  than 
usual,  securities  and  commodities  fall  in  price,  and  working  forces 
are  reduced.  But  there  is  no  epidemic  of  bankruptcy,  no  run 
upon  banks,  and  no  spasmodic  interruption  of  ordinary  business 
processes. 

Crises,  however,  may  degenerate  into  panics.  When  the  process 
of  liquidation  reaches  a  weak  link  in  the  chain  of  interlocking  credits 
and  the  bankruptcy  of  some  conspicuous  enterprise  spreads  unreason- 
ing alarm,  the  banks  are  suddenly  forced  to  meet  a  doubled  strain — 
a  sharp  increase  in  the  demand  for  loans  and  the  demand  for  repay- 
ment of  deposits.  If  the  banks  meet  both  demands,  the  alarm 
quickly  subsides.  But  if  many  solvent  business  men  are  refused 
accommodation  at  any  price  and  depositors  are  refused  payment 
in  full,  the  alarm  turns  into  a  panic.  A  restriction  of  payments  by 
banks  gives  rise  to  a  premium  on  currency,  to  hoarding  of  cash,  and 
to  the  use  of  various  unlawful  substitutes  for  money.  Interest  rates 
may  go  to  three  or  four  times  their  usual  figures,  causing  forced 
suspensions  and  bankruptcies.  There  follow  appeals  to  the  govern- 
ment for  extraordinary  aid,  frantic  efforts  to  import  gold,  the  issue  of 
clearing-house  loan  certificates,  and  an  increase  in  bank-note  cir- 
culation as  rapidly  as  the  existing  system  permits.  Collections  fall 
into  arrears,  workmen  are  discharged,  stocks  fall  to  extremely  low 
levels,  commodity  prices  are  disorganized  by  sacrifice  sales,  and  the 
volume  of  business  is  violently  contracted. 

There  follows  a  period  during  which  depression  spreads  over  the 
whole  field  of  business  and  grows  more  severe.  Consumer's  demand 
declines  in  consequence  of  wholesale  discharge  of  wage-earners.  With 
it  falls  the  business  demand  for  raw  materials,  current  supplies,  and 
equipment.  Still  more  severe  is  the  shrinkage  in  the  investor's 
demand  for  construction  work  of  all  kinds.  The  contraction  in 
the  physical  volume  of  business  which  results  from  these  shrinkages 
in  demand  is  cumulative,  since  every  reduction  of  employment 
causes  a  reduction  in  consumer's  demand,  thereby  starting  again 
the  whole  series  of  reactions  at  a  higher  pitch  of  intensity. 

With  this  contraction  goes  a  fall  in  prices.  For  when  current 
orders  are  insufficient  to  employ  the  existing  equipment,  competition 
for  business  becomes  keener.  This  decUne  spreads  through  the 
regular  commercial  channels  which  connect  one  enterprise  with 
another,  and  is  cumulative,  since  every  reduction  in  price  facilitates 


5i8         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

reductions  in  other  prices,  and  the  latter  reductions  react  to  cause 
fresh  reductions  at  the  starting-point. 

The  fall  in  prices  is  characterized  by  certain  regxilarly  recurring 
differences  in  degree.  Wholesale  prices  fall  faster  than  retail  and 
the  prices  of  raw  materials  faster  than  those  of  manufactured  prod 
ucts.  The  prices  of  raw  mineral  products  follow  a  more  regular 
course  than  those  of  forest  or  farm  products.  Wages  and  interest  on 
long-time  loans  decline  in  less  degree  than  commodity  prices.  The 
only  important  group  of  prices  to  rise  is  high-grade  bonds. 

The  contraction  in  the  volume  of  trade  and  the  fall  in  prices 
reduce  the  margin  of  present  and  prospective  profits,  spread  dis- 
couragements, and  check  enterprise.  But  they  also  set  in  motion 
certain  processes  of  readjustment  by  which  the  depression  is  overcome. 

The  prime  costs  of  doing  business  are  reduced  by  the  fall  in  the 
prices  of  raw  material  and  of  bank  loans,  by  the  marked  increases 
in  the  efficiency  of  labor  which  comes  when  employment  is 
scarce,  and  by  closer  economy  by  managers.  Supplementary  costs 
are  reduced  by  reduction  of  rentals  and  refunding  of  loans,  by  writing 
down  depreciated  properties,  and  by  admitting  that  a  recapitali- 
zation has  been  effected  on  the  basis  of  lower  profits. 

While  costs  are  being  reduced,  the  demand  for  goods  begins 
slowly  to  expand.  Accumulated  stocks  left  over  from  prosperity 
are  exhausted,  and  current  consumption  requires  current  production. 
Clothing,  furniture,  and  machinery  are  discarded  and  replaced. 
New  tastes  appear  among  consumers  and  new  methods  among 
producers,  giving  rise  to  demand  for  novel  products.  Most  important 
of  all,  the  investment  demand  for  industrial  equipment  revives. 
CapitaHsts  become  less  timid  as  the  crisis  recedes  into  the  past,  the 
low  rates  of  interest  on  long-time  bonds  encourage  borrowing,  and 
contracts  can  be  let  on  most  favorable  conditions. 

Once  these  forces  have  set  the  physical  volume  of  trade  to 
expanding  the  increase  proves  cumulative.  Business  prospects 
become  gradually  brighter.  Everything  awaits  a  revival  of  activity 
which  will  begin  when  some  fortunate  circumstance  gives  a  fillip 
to  demand,  or,  in  the  absence  of  such  an  event,  when  the  slow  growth 
of  the  volume  of  business  has  filled  order  books  and  paved  the  way 
for  a  new  rise  in  prices.  Such  is  the  stage  of  the  business  cycle  with 
which  the  analysis  begins,  and,  having  accounted  for  its  own  begin- 
ning, the  analysis  ends.' 

'  It  may  be  added  that  within  the  larger  cycles  are  minor  fluctuations 
which  are  scarcely  less  interesting  than  the  major  movements. 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       519 

Only  a  few  words  of  comment  with  reference  to  this  analysis 
are  necessary.  It  may  be  noted  first  that  the  forces  which 
are  at  work  in  producing  this  ebb  and  flow  of  business  activity 
are  embodied  in  the  very  warp  and  woof  of  the  modern  indus- 
trial and  financial  structure.  It  may  be  concluded  therefore 
that  the  ebb  and  flow  of  business  prosperity  will  continue  so 
long  as  the  present  industrial  and  financial  structure  of  society, 
with  its  profit-making  motivation,  is  maintained.  And  indeed 
under  any  organization  of  society  there  would  be  some  fluctua- 
tion in  the  volume  of  business  activity  consequent  upon  the 
mutations  of  chmate  and  other  uncontrollable  natural  phe- 
nomena. But  undoubtedly  business  fluctuations  are  most 
pronounced  under  the  conditions  that  prevail  in  a  profit- 
making  and  credit  society. 

While  we  may  therefore  regard  the  ebb  and  flow  of  business 
activity  as  the  normal  state  of  affairs,  it  is  possible  that  the 
extent  of  the  oscillations  of  business  may  be  somewhat  modified 
and  that  in  particular  the  panic  stage  may  be  eliminated. 
Indeed,  the  panic  stage  has  been  for  all  practical  purposes 
eliminated  in  European  countries,  and  it  is  hoped  and  pretty 
generally  believed  that  it  has  been  eliminated  in  the  United 
States  in  consequence  of  the  improved  organization  of  our 
banking  machinery  under  the  Federal  Reserve  law.'  If  the 
reader  is  to  appreciate  the  possibility  of  reducing  the  fluctua- 
tions of  business  activity  and  preventing  a  recurrence  of  panics, 
it  will  be  necessary  to  consider  in  some  detail  the  relation  of 
the  commercial  banking  system  to  the  business  cycle. 

III.    COMMERCIAL  BANKING  AND  BUSINESS 
CYCLES 

In  Mitchell's  analysis  it  was  pointed  out  that  in  the  period 
of  depression  bank  reserves  are  large,  with  abundance  of 
loanable  funds  at  low  interest  rates.  This  reserve  situation  is 
due  to  the  contraction  of  deposit  currency  that  occurred  during 
the  liquidation  process  of  the  panic  period,  and  to  the  industrial 

'  For  a  discussion  of  the  possibilities  under  the  Federal  Reserve  System, 
see  pp.  589-600. 


520  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

stagnation  during  the  depression,  which  reduced  the  demand 
for  loanable  funds  to  a  minimum.  This  plethora  of  funds  at 
low  interest  rates  is  not  of  itself  suflScient  to  bring  about  a 
revival  of  business  activity,  as  is  evidenced  by  the  fact  that 
the  depression  often  continues  for  many  years  in  the  face  of 
easy  and  cheap  money.  But  when  once  business  confidence 
has  been  increased — usually  as  a  result  of  some  fortuitous 
development — a  plentiful  supply  of  cheap  funds  becomes  an 
undoubted  factor  in  promoting  the  expansion   of  industry. 

Of  more  significance,  however,  is  the  relationship  of  the 
supply  of  bank  funds  to  the  business  cycle  when  the  upward 
movement  is  approaching  a  critical  stage.  By  virtue  of  their 
control  of  the  purse  strings  the  managers  of  commercial  banking 
institutions  are  in  a  position  to  exercise  a  restraining  influence — 
to  control,  in  fact,  the  rate  of  business  expansion  and  to  prevent 
a  continuance  of  the  upward  swing  to  the  stage  of  acute  crisis 
which  ends  in  financial  collapse  and  panic.  Under  the  American 
banking  system  prior  to  19 14,  however,  American  banks  did 
not  exercise  any  restraining  influence  on  business,  the  banking 
statistics  clearly  indicating  that  no  effort  was  made  on  the 
part  of  the  banks,  as  a  whole,  to  restrict  the  rate  of  expansion. 
The  following  table  shows  the  changes  in  loans,  net  deposits 
(not  including  government),  cash  reserves,  and  reserve  ratio 
at  the  time  of  the  early  autumn  report  on  the  condition  of  the 
national  banks  from  1897  to  1907:' 

The  great  increase  in  the  aggregate  cash  reserves  during  this 
period  is  mainly  attributable  to  the  gold  imports  resulting  from 
our  abnormally  large  exports  of  agricultural  produce  in  the 
early  years  of  the  period,  and  to  the  great  increase  in  gold 
production.  It  will  be  seen  that  there  was  a  very  marked 
decline  in  the  ratio  of  reserves  to  net  deposits.  And  as  the 
chart  on  page  498  indicates,  the  reserves  of  the  individual 
national  banks  were  very  near  the  minimum  requirement. 
The  slight  improvement  that  is  noted  between  September  4, 
1906,  and  August  22,  1907,  does  not  indicate  that  the  banks 

'  From  O.  M.  W.  Sprague,  Crises  under  the  National  Banking  System, 
p.  218. 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       521 


were  exercising  credit  restraint  during  that  period;  for  th 
fact  that  the  bank  returns  in  1907  were  received  by  the  Comp- 
troller of  the  Currency  two  weeks  earlier  than  in  1906  is  sufficient 
to  account  for  the  difference,  since  the  seasonal  strain  on  the 
money  market  is  normally  more  acute  in  September  than  in 
August. 

(Amounts  expressed  in  millions) 


Ratio  of 
Reserve  to 
Deposits 


Oct.  s,  1897 
Sept.  20,  1898 
Sept.  7,  1899 
Sept.  5,  1900 
Sept.  30,  1901 
Sept.  15,  1902 
Sept.  9,  1903 
Sept.  6,  1904 
Aug.  25,  190S 
Sept.  4,  1906 
Aug.  22,  1907 


Loans 

Net  Deposits 

Cash  Reserve 

$2,066 

$2,179 

$388.9 

2,172 

2,404 

420.7 

2,496 

2,952 

466.3 

2,686 

3,187 

518. s 

3,018 

3,554 

539-5 

3,280 

3,720 

508.0 

3,481 

3,863 

554-3 

3,726 

4,400 

661.  s 

3,998 

4,735 

665.6 

4,298 

4,927 

626.0 

4,678 

5,256 

701.6 

Per  Cent 
17.9 
17 
15 
16 

15 
13 
14 

IS 

14 

12 
13 


The  failure  of  the  banks  to  exercise  any  restraining  influence 
on  the  situation  cannot  be  attributed  to  any  lack  of  evidence 
that  the  situation  was  in  need  of  control.  As  early  as  the 
San  Francisco  earthquake,  on  April  18,  1906,  there  were  numer- 
ous indications  that  the  upward  swing  of  the  business  cycle 
was  entering  upon  the  critical  stage.  There  was  sharp  tension 
in  the  money  markets  whenever  any  marked  variation  in  the 
demand  for  loans  occurred;  there  were  practically  no  idle 
funds  available  for  capital  requirements  and  the  supply  of 
loanable  funds  was  inadequate  for  the  needs  of  a  still  expanding 
business,  conducted  at  constantly  rising  prices.  In  fact, 
practically  all  of  the  warning  signs  to  which  Mitchell  makes 
reference  in  his  analysis  were  clearly  in  evidence.  And  in 
March,  1907,  occurred  a  stock  market  panic,  attended  by 
some  of  the  severest  declines  ever  known  on  the  New  York 
Stock  Exchange.  It  had,  however,  no  appreciable  effect  upon 
either  business  or  banking  psychology. 


522  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

A  few  of  the  really  studious  and  far-sighted  bankers,  it  is 
true,  realized  the  gravity  of  the  situation  and  counseled  a  policy 
of  extreme  conservatism  in  the  granting  of  loans.  The  following 
statement  made  before  the  New  York  State  Bankers'  Associa- 
tion by  its  president  on  Jime  27,  1907,  less  than  four- months 
before  the  panic,  is  indicative  of  the  best  banking  thought:* 

Until  very  recently  no  one  admitted  that  his  judgment  dictated 
any  policy  of  retrenchment.  Gentlemen,  we  cannot  hold  the  present 
pace.  We  should  not  hold  it,  even  if  we  could.  Though  our  deposi- 
tors do  not  realize  this,  ova  impleasant  but  perfectly  plain  duty  is  to 
cvirtail  their  accommodation  hues  and  force  retrenchment.  We  are 
in  an  era  of  extravagance,  both  corporate  and  individual,  of  extrava- 
gance in  enterprise  and  of  extravagance  in  expenditure;  extravagance 
as  much  beyond  precedent  as  is  our  feverish  business  activity. 

Expansion  is  not  confined  to  the  industrial  and  commercial 
world.  For  years  banking  facilities  have  been  expanding  out  of  all 
proportion  to  the  growth  of  cash  reserves.  For  several  years  there 
has  not  been  a  week  in  which  all  the  New  York  clearing-house  banks 
have  held  full  reserves,  and  frequently  half,  or  nearly  half,  have 
been  short.  The  same  tendency  prevails  throughout  the  coimtry. 
Is  it  not  time  for  bankers  to  check  this  undue  expansion,  to  prune 
this  tree  too  luxuriant  for  its  roots,  this  fabric  of  credit  built  on  an 
inadequate  foundation  of  reserve  ? 

Independent  decentralized  banking  was  responsible  for  the 
lack  of  credit  control.  "Little  heed  seems  to  have  been  given  to 
these  warning  signs,  but  much  was  made  of  every  straw  which 
suggested  a  possible  further  advance."  This  statement  is 
applicable  both  to  the  business  world  and  to  the  banking 
community  as  a  whole,  as  the  statistics  of  bank  loans  and 
reserves  shown  in  the  table  above  so  clearly  reveal.  The 
explanation  of  this  failure  of  the  banks  to  control  the  situation 
has  usually  been  assigned  to  the  American  system  of  decentral- 
ized and  independent  banking,  that  is,  a  system  where  the 
banks  are  not  united  through  a  centralized  agency  and  where 
each  particular  banker  formulates  his  banking  policy  in 
accordance  with  his  own  individual  views — or  lack  of  them. 

'  Elliot  C.  McDougal,  Bankers'  Magazine,  LXXV,  No.  I,  p.  i. 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES      523 

In  describing  the  weaknesses  of  this  system,  a  prominent  student 
of  banking  reform  says:' 

The  managers  of  each  bank  have  the  power  to  regulate  the 
amount  of  its  loans  and  discounts  and  the  expansion  of  its  deposit 
Kabilities  in  relation  to  reserves,  having  regard  to  the  condition  of 
the  particular  bank  which  they  control;  but  in  the  United  States 
bank  managers  have  no  power  to  regulate  the  expansion  of  credits 
of  all  the  banks  with  a  view  to  the  security  of  the  general  credit 
situation,  and  have  no  power,  through  the  issue  and  redemption  of 
bank  notes,  to  prevent  sudden  and  wide  fluctuations  in  the  credit 
power  of  the  banks  resulting  from  the  fluctuations  of  the  volume  of 
currency  used  as  a  circulating  medium.  Though  the  managers  of 
fifty,  or  of  a  hundred,  out  of  the  seven  thousand  national  banks  may 
be  of  the  opinion  that,  having  regard  to  existing  or  prospective 
conditions,  the  expansion  of  credits  has  gone  too  far,  they  have  no 
power  to  accomphsh  any  substantial  result.  They  could  restrict 
the  grant  of  credits  by  their  own  banks,  and  so  lose  profitable  business 
that  would  go  to  other  banks,  but  they  could  not  materiaUy  improve 
the  general  situation.  This  was  the  case  prior  to  the  recent  panic. 
For  months  before  the  panic  many  intelligent  managers  of  banks 
and  trust  companies  knew  that  the  credit  situation  throughout  the 
country  had  become  strained,  and  accordingly,  by  restricting  credits 
and  by  making  call  loans  instead  of  time  loans,  many  of  them  endeav- 
ored to  strengthen  their  own  institutions,  but  they  could  do  little 
for  the  protection  of  the  general  credit  situation. 

This  failure  of  either  business  men  or  bankers  to  realize 
the  critical  condition  of  business  and  to  exercise  any  restraining 
influence  over  its  further  expansion  permits  a  continuation 
of  great  business  activity  until  it  culminates  in  the  stage  of 
acute  crisis,  followed  by  panic.  We  may  now  consider  the 
situation  as  it  exists  in  the  weeks  immediately  preceding  the 
suspension  of  specie  payments. 

Concreteness  will  be  given  to  the  problem  if  we  preface 
the  discussion  of  the  strain  upon  the  banking  system  with  ^ 
brief  outline  of  the  events  of  a  typical  crisis.  The  panic  oi 
1907 — that  is,   the  suspension  of  specie  payments  and   the 

*  Victor  Morawetz,  The  Banking  and  Currency  Problem  in  the  United 
States,  p.  36.     (North  American  Review  Publishing  Co.,  1909.) 


524  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

general  collapse  of  the  credit  structure — occurred  on  October  22. 
During  the  month  of  September  collection  of  business  accounts 
was  very  slow,  and  the  number  of  manufacturing  failures  was 
five  times  as  great  as  in  September,  1906.  Where  in  the 
preceding  months  there  had  been  perhaps  a  few  hundred 
people  who  realized  that  economic  and  financial  conditions 
were  in  a  critical  state,  it  had  now  become  apparent  to  many 
thousands  of  business  men  that  serious  trouble  was  imminent. 
DecUning  sales,  poor  collections,  inability  to  secure  funds — 
these  were  facts  actually  existent;  foresight  was  no  longer 
required  to  adjudge  the  situation  as  grave. 

The  spectacular  part  of  the  crisis  came  with  the  failure  of 
certain  important  financial  institutions.  The  first  of  these  was 
the  stock  exchange  firm  of  which  Otto  C.  Heinze  was  president. 
This  firm  had  been  endeavoring,  without  success,  to  secure  a 
comer  on  the  copper  market,  and  was  finally  caught  on  a 
declining  market.  There  was  a  well-defined  suspicion  that 
F.  Z.  Heinze,  who  was  president  of  the  Mercantile  National 
Bank,  was  interested  in  his  brother's  ventures  in  copper  and 
that  funds  of  the  bank  were  being  used  in  connection  with 
copper  speculation.  Rightly  or  wrongly,  he  and  his  financial 
allies,  who  dominated  seven  banks  and  a  trust  company, 
possessing  capital  stock  of  $21,000,000  and  deposits  of 
$71,000,000,  fell  into  public  disfavor.  The  New  York  Clearing- 
House,  either  because  it  believed  the  banks  in  question  would 
be  able  to  weather  the  storm  or  through  fear  of  the  effects 
of  their  failure  upon  the  credit  structure  in  general,  agreed  to* 
render  these  banks  assistance,  provided  Heinze  and  his  asso- 
ciates were  eliminated  from  their  control.  An  announcement 
to  this  effect  was  made  on  October  21.  On  the  very  day  of 
this  announcement,  however,  the  National  Bank  of  Cominerce 
proclaimed  that  after  October  22  it  would  not  be  responsible 
for  the  clearing  of  checks  drawn  against  the  Knickerbocker 
Trust  Company,  whose  president  was  thought  to  be  allied 
with  Heifize  and  his  associates.  This  action  at  once  brought 
the  Knickerbocker  Trust  Company  under  public  suspicion 
and  a  run  by  depositors  was  started  on  the  bank,  which  closed 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       525 

its  doors  after  paying  out  eight  million  dollars  in  three  hours. 
The  resulting  loss  of  confidence  was  followed  by  runs  on  the 
Lincoln  Trust  Company  and  the  Trust  Company  of  North 
America.  These  failures  were  in  turn  followed  by  several 
conspicuous  commercial  failures;-  and  banks  in  general  shortly 
"suspended  specie  payments  for  safety's  salie. " 

The  great  need  in  time  of  crisis  is  for  additional  bank  currency, 
partly  in  the  form  of  bank  notes,  but  more  largely  in  the  form  of 
deposit  or  credit  currency.  The  reason  for  the  pressure  upon 
the  banks  for  additional  accommodation  during  a  period  such 
as  has  just  been  outlined  can  best  be  appreciated  by  considering 
the  financial  position  of  the  individual  business  men,  who 
constitute  the  source  of  bank  borrowing.  In  this  connection 
the  reader  should  recall  the  interdependency  of  the  credit 
system  and  the  strains  and  stresses  that  have  already  appeared 
before  the  stage  of  acute  crisis  has  been  reached.  In  a  period 
when  sales  are  falling  off,  with  collections  slow  and  the  business 
future  shrouded  in  uncertainty,  there  is  a  twofold  reason  why 
business  men  must  seek  unusually  large  accommodations  from 
the  banks. 

In  the  first  place,  many  loans  are  then  required  which 
would  not  be  needed  if  collections  were  normal.  Concretely, 
Y  had  been  counting  on  paying  Z  out  of  funds  received  from  X; 
but  if  X  does  not  pay  Y,  then  Y  must  either  seek  a  loan  from 
his  bank  with  which  to  pay  Z  or  else  ask  Z  to  wait  for  payment. 
In  order  to  maintain  their  own  credit  standing  in  the  trade, 
many  concerns  thus  placed,  particularly  those  who  pride 
themselves  on  always  meeting  their  obligations  promptly, 
choose  the  first  alternative,  that  of  seeking  additional  accom- 
modation from  the  banks.  The  total  added  strain  that  is 
thereby  placed  upon  the  banks  is  in  fact  enormous. 

In  the  second  place,  many  business  men  procure  in  a  time 
of  credit  strain  what  may  be  called  "anticipatory"  loans. 
Normally,  funds  are  not  borrowed  until  they  are  needed; 
but  in  times  of  great  monetary  and  business  uncertainty,  when 
interest  rates  are  rapidly  rising,  and  when  there  is  imminent 
possibility  of  one's  not  being  able  to  secure  funds  at  any  price 


526  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

in  the  near  future,  many  loans  are  in  fact  contracted  before 
the  actual  need  for  funds  has  arisen.  It  is  a  case  of  being 
forearmed  for  trouble — by  seciuring  banking  credits  while 
the  opportunity  is  still  open. 

The  outstanding  need  id  time  of  crisis  is  therefore  an 
expansibility  of  the  loaning  power  of  the  banks.  We  have 
said  that  the  need  is  partly  for  bank  notes,  but  more  largely 
for  deposit  currency.  Interestingly  enough,  the  general  public 
has  always  assumed  that  the  need  in  time  of  crisis  is  primarily 
for  increased  quantities  of  circulating  media  in  the  form  of  notes. 
The  fact  is,  however,  that  the  great  demand  for  actual  currency 
comes  after  the  suspension  of  specie  pajonents,  when  the 
checking  system  has  ceased  to  function.  Then  it  is,  and  not 
until  then,  that  the  "currency  famine"  impresses  the  general 
public.  This  is  not  to  say  that  there  is  not  a  need  for  an 
increased  quantity  of  bank  notes  in  the  period  preceding  the 
suspension  of  specie  payments.  In  the  rural  sections  and  to 
some  extent  in  the  financial  centers,  owing  mainly  to  a  hoarding 
of  currency,  there  is  an  vmdoubted  need  for  large  additional 
quantities  of  bank  notes.  But  for  the  reasons  that  we  have 
already  discussed,  in  studying  the  elasticity  of  our  bank-note 
currency  for  seasonal  needs,  it  has  proved  impossible  for  the 
banks  to  meet  the  demand  for  more  notes.  Here  then  is  one 
important  source  of  weakness  in  our  commercial  banking  system. 

But  where  there  is  a  demand  in  the  pre-panic  period  for  a 
thousand  dollars  of  additional  bank  notes,  there  is  a  demand 
for  millions  of  dollars  of  deposit  currency.  The  banks  as  a 
whole  cannot,  however,  make  additional  loans  and  create 
additional  deposit  currency  unless  they  can  secure  increased 
reserves.  Hence  the  crux  of  the  problem  in  the  period  of 
acute  crisis  lies  with  the  condition  of  bank  reserves. 

In  the  period  before  the  establishment  of  the  Federal 
Reserve  System,  the  fact  is  that  it  was  impossible  for  the  banks 
to  increase  the  quantity  of  bank  reserves.  It  obviously  was 
out  of  the  question  to  secure  a  quick  increase  in  the  quantity 
of  gold  production  and  it  was  usually  impossible  to  secure 
enough  specie  from  other  countries,  owing  to  the  inability  of 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       527 

OUT  independent  banks  to  unite  in  a  policy  of  raising  interest 
rates  to  a  point  which  would  attract  gold  from  abroad.  All 
the  other  forms  of  our  currency,  as  we  have  already  seen,  are 
inelastic;  hence  all  the  banks  could  do  was  to  conserve  their 
existing  reserves  as  best  they  might. 

Hoarding  cash  intensifies  the  difficulties  in  time  oj  crisis. 
In  fact,  however,  they  were  never  able  to  make  a  very  effective 
use  of  these  reserves.  As  soon  as  a  general  public  distrust 
of  banking  institutions  develops,  j&rightened  bank  depositors 
usually  begin  to  withdraw  cash  so  that  in  the  event  of  panic 
their  money  will  be  safe.  This  withdrawal  of  cash,  however, 
makes  a  bad  situation  very  much  worse;  for  it  depletes  reserves 
at  the  very  time  when  banks  should  be  enabled  to  increase 
their  cash  holdings  as  a  means  of  extending  loans  with  which  to 
meet  the  insistent  demands  of  business  for  funds.  Hoarding 
thus  results  in  a  sharp  restriction  of  the  lending  power  of  the 
banks.  It  should  be  borne  in  mind  in  this  connection  that 
for  every  dollar  of  actual  cash  that  is  withdrawn  from  the 
banking  system  as  a  whole,  some  ten  dollars  of  lending  power  is 
curtailed.^ 

Redepositing  bank  reserves  is  a  potent  source  of  difficulty. 
The  practice  of  depositing  reserve  funds  of  country  banks 
in  the  financial  centers  still  further  increases  the  strain  upon  the 
banks  of  these  centers  in  time  of  crisis.  Indeed,  Professor 
Sprague  tells  us  that  "  there  has  been  no  crisis  since  the  estab- 
lishment of  the  national  banking  system  (in  1863),  in  which 
the  New  York  banks  would  have  been  at  all  likely  to  have 
resorted  to  suspension  had  their  difl&culties  been  confined  to 
those  of  purely  local  origin. "  There  has  been  a  tendency  when 
confronted  with  acute  crisis  for  each  and  every  bank,  under  our 
decentralized  banking  system,  to  attempt  self-preservation; 
each  seeks  to  seize  and  hold  all  the  cash  that  is  obtainable. 
There  is  in  fact  a  wild  scramble  for  money — with  the  devil 
getting  the  hindmost. 

'  See  discussion  of  this  point  on  pp.  483-85.  At  the  present  time, 
it  sbouI4  be  ^-egalled,  it  means  about  a  twenty-to-gne  curtailment. 


528  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

This  scrambling  for  currency  among  the  banks  serves 
very  quickly  to  reduce  the  reserves  in  the  central  cities  far 
below  the  legal  minima.  It  will  be  recalled  that  the  deposits 
of  the  country  banks  are  placed  in  the  financial  centers  on 
demand,  that  is,  subject  to  call  at  a  moment's  notice.  It  will 
also  be  recalled  that  by  virtue  of  our  system  of  redepositing 
funds,  reserves  often  serve  Jn  several  places  simultaneously. 
Now  so  long  as  no  exceptional  strain  is  placed  upon  the  money 
market  this  system  appears  satisfactory  enough;  but  in  time 
of  crisis  the  hard  truth  is  revealed  that  the  only  effective 
reserve  is  actual  specie.  For  if  a  country  bank  succeeds  in 
withdrawing  funds  from  the  financial  centers,  its  position  is 
strengthened,  but  the  bank  from  which  its  reserve  is  withdrawn 
finds  itself  in  a  correspondingly  weakened  position.  If,  on  the 
other  hand,  the  banks  in  the  financial  centers  refuse  to  return 
the  bankers'  deposits  on  demand,  this  means  at  once  a  suspen- 
sion of  specie  payments  and  the  breakdown  of  the  credit  system 
in  general.  It  appears  to  be  a  common  view  of  students  of 
the  question  that  the  former  alternative  was  the  lesser  of  two 
evils,  and  it  is  believed  that  in  some,  at  least,  of  the  major 
panics  of  the  last  forty  years  a  courageous  meeting  of  all  demands 
for  cash  would  have  avoided  the  worst  phases  of  the  panic. 

The  strain  on  the  banks  of  the  financial  centers  was,  however, 
undoubtedly  very  severe.  In  1907,  $4,400,000  of  currency 
was  shipped  from  New  York  to  the  West  during  the  week 
ending  October  19,  and  for  the  week  ending  November  16, 
$22,600,000  was  sent  to  the  interior.  The  New  York  Clearing- 
House  Committee,  moreover,  answers  its  critics  who  insist 
that  a  complete  breakdown  of  the  credit  structure  throughout 
the  country  might  have  been  avoided  if  the  New  York  banks 
had  more  fully  responded  to  the  demands  of  country  corre- 
spondents by  saying: 

To  have  fully  honored  the  demands  that  were  pouring  in  from 
all  sections  of  the  country  would  have  dissipated  our  banking  reserve 
in  a  fortnight.  How  could  it  be  replenished?  What  would  have 
been  the  effect  on  the  country  if  the  New  York  bank  reserve  had 
been  entirely  depleted?    It  would  have  so  intensified  the  panicky 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       529 

feeling  that  widespread  commercial  disaster  would  have  resulted. 
The  $53,000,000  deficit  in  our  banking  reserve  occurred  in  less  than 
ten  days  after  the  failure  of  the  Knickerbocker  Trust  Company, 
and  was  caused  by  the  shipment  to  interior  institutions  of  the  larger 
portion  of  that  amount  in  that  short  time.  We  kept  the  door  of 
our  treasure-house  wide  open  imtil  for  the  good  of  the  country  it 
became  necessary  everywhere  to  close  it. 

Other  financial  institutions  are  dependent  upon  the  com- 
mercial bankers.  We  have  elsewhere  seen  that  the  commercial 
banks  act  as  the  repositories  of  funds  for  other  financial  insti- 
tutions as  well  as  for  the  general  business  public.  Savings 
banks,  bond  houses,  and  insurance  companies  keep  a  portion 
of  their  funds  on  deposit  with  commercial  institutions.  More- 
over, directly  and  indirectly  they  look  to  the  commercial  banks 
for  accommodation  in  time  of  strain;  that  is  to  say,  they  either 
seek  to  secure  from  the  commercial  banks  loans  with  which  to 
tide  themselves  over  difficulties,  or  through  the  sale  of  securities 
they  endeavor  to  shift  the  burden  of  the  financial  strain  to 
the  commercial  institutions. 

Trust  companies  have  also  been  dependent  upon  the 
commercial  banks.  This  is  particularly  true  of  the  commercial 
banking  departments  of  the  trust  companies.  Maintaining 
low  reserves  of  their  own  and  keeping  a  portion  of  these  on 
deposit  with  commercial  banks,  they  promptly  attempt  to 
shift  the  strain  to  which  they  are  subjected  in  time  of  crisis 
to  the  commercial  banks,  either  by  a  withdrawal  of  their 
reserve — as  in  the  case  of  country  commercial  banks — or  by 
attempting  to  dispose  of  security  holdings  on  a  stagnant  market.^ 

Loans  were  in  fact  typically  contracted  rather  than  expanded. 
The  banks  of  the  financial  centers  are  in  a  sense  caught  between 
the  upper  and  nether  millstones.  An  excessive  demand  for 
loans  is  placed  upon  them  9,t  a  time  when  there  is  a  rapid 
depletion  of  reserves  as  a  result  of  individual  hoarding  and  of 
the  withdrawal  of  bankers'  balances.  It  is  not  surprising 
therefore  that  the  banks  were  unable  to  expand  the  volume 
of  loans  and  prevent  a  general  collapse  of  business.     (It  should 

'  See  pp.  531-32. 


530 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


be  noted  in  passing  that  even  if  the  banks  had  been  able 
to  maintain  the  convertibility  of  deposits  into  cash,  they  could 
not  have  sustained  the  business  structure,  unless  they  could 
have  expanded  the  volume  of  their  loans.)  The  following 
data'  bearing  on  the  crisis  which  came  to  a  head  on  September 
20,  1873,  show  what  actually  occurred: 


Country 
Banks 

Reserve  City 
Banks 

Banks  in 
New  York 

Total 

Sept.  12,  1873 

$478.5* 
455-8 
442.0 

$262.5 

247-5 
242.2 

$199.2 
179. 1 
i6g.i 

$940.2 
882.4 
853-4 

Oct.    13,  1873 

Nov.    I,  1873 

*  000,000  omitted. 

The  contraction  of  loans  between  September  12  and  October  13 
indicates  the  sheer  inability  of  the  banks  to  perform  the  func- 
tions required.  Rather  than  a  contraction  of  loans  there 
should  have  been  a  very  great  expansion  in  order  to  tide  the 
business  world  over  the  critical  period.  In  the  better  organized 
European  banking  systems  a  sharp  expansion  of  loans  has 
always  occurred  with  a  result  that  a  general  financial  panic 
has  been  avoided — although  European  crises  are  followed  by 
a  period  of  gradual  liquidation  and  by  a  general  business 
depression  of  considerable  duration. 

The  Treasury  gave  what  aid  it  could.  During  the  ten  days 
from  October  21  to  31,  1907,  the  federal  Treasury  transferred 
to  the  national  banks  of  New  York  City  $37,597,000.  Since 
the  strain  in  this  panic  at  the  beginning  was  greatest  upon 
the  trust  companies,  the  national  banks  transferred  these 
funds  to  the  trust  companies  in  order  to  prevent  a  run  upon 
them.  The  Treasury  Department  also  furnished  the  New 
York  banks  about  $36,000,000  in  small  bills  with  which  to 
meet  the  demands  of  the  interior  for  currency."  As  the 
stringency  progressed,  the  Treasury  gave  relief  in  every  impor- 
tant locality  where  assistance  seemed  to  be  required.  By  the 
middle  of  November  the  Treasury  had  deposited  in  the  banks 

'  From  O.  M.  W.  Sprague,  History  of  Crises  under  the  National 
Banking  System,  p.  82. 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES      531 

all  the  money  it  could  spare;  indeed,  it  had  reduced  its  working 
surplus  to  about  $5,000,000." 

By  way  of  indirect  aid  the  Secretary  of  the  Treasury  resorted 
to  various  means  of  stimulating  the  purchase  of  government 
bonds  as  security  for  note  issues;  but  relatively  little  was 
accomplished.  Indeed,  Treasuary  aid  can  count  for  little,  at 
best;  whether  it  can  be  of  assistance  at  any  particular  time 
depends  upon  the  chance  possession  of  ample  funds  at  such  a 
time.  This  fact  renders  the  system  of  no  value  as  a  scientific 
mode  of  relief  in  time  of  crisis. 

Secondary  reserves  avail  hut  liUle  in  time  of  crisis.  Thus 
far  nothing  has  been  said  about  the  steps  that  were,  or  might  be, 
taken  by  the  banks,  particularly  those  of  the  financial  centers, 
for  the  replenishment  of  their  cash  reserves,  through  the  con- 
version into  specie  of  their  "liquid  assets."  As  noted  in  a 
preceding  chapter,  the  problem  of  successful  bank  management 
is  said  to  involve  the  making  of  loans  of  such  a  nature  that  they 
can  be  relied  upon  to  furnish  cash  in  case  of  need.  The  bank's 
assets  other  than  cash  are  looked  upon  as  a  sort  of  secondary 
reserve — as  assets  which  can  be  relied  upon  to  liquidate  them- 
selves in  case  of  need. 

Call  loans  were  long  regarded  as  an  admirable  form  of 
secondary  reserve,  for  the  reason  that  they  could  be  converted 
into  cash  upon  a  moment's  notice.  Viewed  from  the  standpoint 
of  the  individual  bank,  call  loans  appear  to  possess  an  ideal 
liquidity;  and  in  ordinary  times,  indeed,  any  one  bank  may 
replenish  its  funds  by  calling  loans.  In  the  event  that  the 
loan  is  paid  by  the  borrower,  well  and  good.  In  the  event  that 
the  loan  is  not  paid,  the  collateral  can  readily  be  disposed  of  on 
the  stock  exchange,  the  funds  for  the  purpose  being  drawn  from 
some  other  banking  institution.  In  time  of  crisis,  however, 
it  has  been  found  that  the  calling  of  loans  furnishes  no  con- 
siderable relief;  for  when  all  banks  are  hard  put  for  funds  and 
all  are  endeavoring  to  sell  collateral  simultaneously,  with 
none  wishing  to  buy,  the  market  for  securities  becomes  auto- 
matically stagnant.  Hence  calling  loans  is  a  futile  expedient, 
when  viewed  from  the  standpoint  of  the  system  as  a  whole. 


532  THE  FINANCIAI.  ORGANIZATION  OF  SOCIETY 

Tline  collateral  loans  have  never  been  regarded  by  the  banks 
as  particularly  liquid  in  time  of  crisis.  Only  a  few  of  them  at 
such  a  time  would  be  paid  as  they  matured,  and  if  they  were 
not  paid,  it  would  be  just  as  impossible  to  sell  the  collateral 
security  as  to  dispose  of  call  loan  collateral. 

Investments  in  readily  marketable  bonds  have  also  been 
revealed  as  impotent  to  secure  the  needed  replenishment  of 
reserves;  for,  a?  in  the  case  of  the  collateral  back  of  call  loans, 
th?re  is  no  market  for  bonds  when  all  banks  simultaneously 
are  endeavoring  to  dispose  of  them. 

Commercial  loans  are  not  liquid  in  time  of  crisis.  But  is 
not  the  commercial  paper  of  customers,  when  based  upon 
"legitimate  business  transactions  involving  the  flow  of  goods 
from  producer  to  consumer"  automatically  self -liquidating 
and  hence  absolutely  reliable  in  time  of  crisis  ?  This  is  indeed 
the  general  banking  theory  and  it  is  the  theory  underlying  the 
banking  legislation  of  our  own  and  other  countries.  Com- 
mercial paper,  it  is  said,  being  based  upon  the  purchase  and 
sale  of  goods,  or,  as  the  case  may  be,  upon  the  ascertained 
excess  of  income  over  outgo  during  the  life  of  the  loan,^  is 
certain  to  be  paid  at  maturity. 

The  truth  is,  however,  that  this  is  a  fundamentally  fallacious 
doctrine.  Before  the  establishment  of  the  Federal  Reserve 
System  the  most  unliquid  asset  in  a  bank's  portfolio,  both  in 
ordinary  times  and  in  periods  of  stress,  was  the  commercial 
paper  of  customers.  It  is  not  true,  in  the  first  place,  that  even 
in  ordinary  periods  such  loans  are  normally  paid  at  maturity; 
the  fact  is  that  they  are  more  often  renewed  than  paid.  Banks, 
indeed,  have  a  general  policy  of  requiring  their  customers  to 
liquidate  their  indebtedness  only  once  each  year.  Investiga- 
tion, moreover,  reveals  that  in  many,  and  in  a  steadily  increasing 
number  of  lines  of  industry,  there  is  far  from  a  complete  liquida- 
tion of  indebtedness  once  a  year.  Where  loans  are  paid  ofiF  to 
bank  A  the  concern's  working  capital  is  commonly  replenished 
by  borrowing  from  bank  B,  either  directly  or  indirectly  through 
the  intermediary  of  a  commercial  paper  house. 

» See  discussion  on  pp.  377-83. 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       533 

There  are  seasonal  variations,  it  is  true,  in  the  total  demand 
for  bank  funds  and  in  the  total  of  outstanding  bank  loans,  but 
there  is  never  any  period  when  it  is  unnecessary  for  the  banking 
system  as  a  whole  to  carry  business  as  a  whole.  In  ordinary 
times,  moreover,  as  noted  in  the  preceding  chapter,  the  banks 
rely  for  funds  with  which  to  meet  temporary  needs  not  primarily 
upon  maturing  commercial  paper,  but  upon  the  sale  of  collateral 
or  securities,  or  upon  borrowing  from  a  correspondent  bank  in 
one  or  another  of  numerous  ways.  Liquidity  is  tantamount 
to  shiftability. 

When  the  crisis  has  developed  it  would  be  absolutely  futile 
for  the  bank  to  rely  upon  an  inflow  of  funds  from  maturing 
loans  as  a  means  of  replenishing  its  reserves.  At  such  a  time 
renewals  are  certain  to  be  almost  universally  demanded.  It  is 
a  first  principle  that  the  bank's  customers  must  be  carried  in  a 
time  of  stress.  We  have  already  seen  that  there  is  an  enor- 
mously increased  demand  for  accommodation  at  such  a  time, 
that  the  fundamental  need  is  for  an  expansion  of  loans,  and 
that  to  contract  them  would  precipitate  the  panic  at  once. 

Our  own  banking  experience,  as  well  as  that  of  all  othe; 
countries,  has  taught  with  the  greatest  possible  conclusiveness 
that  the  ability  to  pass  through  a  crisis  without  credit  dis- 
ruption rests  not  upon  the  ability  of  the  banks  to  convert 
assets  int3  cash^ — for  nothing  is  liquid  in  time  of  crisis;  it  rests 
upon  their  ability  either  to  draw  upon  unused  reservoirs  of 
reserves  or  to  create  new  forms  of  reserve  money  that  can  be 
used  as  a  basis  for  an  expansion  of  loans.' 

Banks  have  sought  some  relief  through  what  is  known  as  the 
equalization  of  reserves  and  the  utilization  of  clearing-house  loan 
cer'ificaks.  The  equalization  of  reserves  involves  what  amounts 
Lo  a  pooling  of  the  cash  resources  of  the  members  of  the  clearing- 
house association.  Some  banks,  of  course,  have  larger  reserves 
than  others  and  some  links  in  the  chain  are  accordingly  weaker 
than  others.    An  equalization  of  reserves  is  thus  designed  to 

'  For  a  fuller  discussion  of  the  liquidity  of  bank  assets,  see  the  author's 
"Commerciai  Banking  and  Capital  Formation,"  Journal  of  Political 
Economy,  XXVI  (1918),  706-31. 


534  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

equalize  the  resisting  power  of  the  banks  in  meeting  the  demands 
against  them.  A  clearing-house  loan  certificate  differs  from  the 
clearing-house  certificate  discussed  on  pages  460-61  above  in 
that,  instead  of  being  a  claim  check  to  cash  that  is  on  deposit 
in  clearing-house  vaults,  it  is  in  the  nature  of  a  loan  from  the 
clearing-house,  on  the  security  of  collateral  deposited  with  a 
clearing-house  committee. 

A  brief  statement  of  the  history  of  attempts  by  the  clearing- 
house associations  to  meet  the  strains  placed  upon  them  in 
time  of  crisis  will  throw  light  both  upon  an  interesting  phase  of 
banking  competition  and  upon  the  question  of  the  type  of 
banking  organization  that  is  needed  to  control  the  credit 
situation  at  such  periods.  The  use  of  these  expedients  by  the 
clearing-house  associations  grew  out  of  a  plan  that  was  appar- 
ently devised  shortly  after  the  crisis  of  1857.  They  were  first 
tried  out  in  the  rather  severe  financial  strain  of  1860-61,  when 
the  banks  succeeded  in  passing  the  crisis  without  suspension  of 
specie  payments.  In  order  to  ascertain  the  ef&cacy  of  the 
devices  in  question,  it  will  be  necessary  to  consider  specifically 
the  way  in  which  each  is  designed  to  relieve  the  strain. 

If  the  clearing-house  loan  certificate  were  resorted  to  only 
by  those  banks  which  had  adverse  balances  to  pay,  the  result 
would  be  that  such  banks  would  be  enabled  to  maintain  intact 
their  existing  reserves,  so  far  as  payments  to  other  banks  were 
concerned.  This  would  not,  however,  prevent  a  withdrawal  of 
funds  by  individual  depositors.  Now  if  the  only  banks  which 
resorted  to  the  clearing-house  certificates  were  those  whose 
reserves  were  very  low,  and  if  the  others  continued  to  pay  cash, 
there  would  in  effect  be  some  equalization  of  reserves,  the 
banks  with  large  cash  reserves  paying  their  adverse  balances  in 
specie,  and  the  banks  with  low  cash  reserves  postponing  the 
payment  of  theirs.  But  in  practice  all  of  the  banks,  as  a  matter 
of  fact,  resorted  to  the  use  of  the  clearing-house  loan  certificate 
simultaneously,  with  a  result  that  this  device  gave  only  a 
negative  help  to  the  banks  whose  reserves  were  low.  It  pre- 
vented a  further  depletion  of  them  by  payments  of  adverse 
balances  at  the  clearing-house.    So  far  as  the  relations  betweeq 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       535 

banks  were  concerned,  it  amounted  to  a  maintenance  of  the 
status  quo  in  the  matter  of  reserves.  It  will  thus  be  seen  that 
the  use  of  the  clearing-house  loan  certificate  prevented  the 
banks,  to  some  extent,  from  working  at  cross-purposes,  with 
resulting  failure  for  some  of  them  and  consequent  reaction 
upon  all  the  rest.  This  device  could  not,  however,  prevent  the 
failure  of  banks  whose  reserves  were  depleted  as  a  result  of 
heavy  withdrawals  of  specie  by  depositors.  In  other  words, 
it  could  not  materially  strengthen  the  weak  links  of  the 
chain. 

But  the  process  of  equalizing  reserves,  on  the  other  hand, 
had  more  than  a  negative  effect.  By  pooling  reserves  the 
banks  whose  funds  were  low  became  as  strong  as  any  other 
banks;  each  bank,  in  effect,  was  considered  as  having  the 
same  reserve  as  any  other;  no  weak  links  remained,  however 
delicate  the  chain  as  a  whole  might  be.  While  the  two  devices 
■differ  somewhat  in  scope  and  purpose,  it  should  be  imder stood 
that  they  were  designed  to  be  used  together. 

The  failure  of  the  system  of  clearing-house  loan  certificates 
and  equalization  of  reserves  in  the  panic  of  1873  is  largely 
attributable  to  the  practice  of  paying  interest  upon  out-of-town 
bankers'  deposits  by  the  New  York  banks,  a  practice  that 
was  largely  responsible  for  the  concentration  of  funds  in  the 
metropolis  through  attracting  reserves  from  the  interior  of  the 
country.  It  had  been  expected  at  the  time  the  arrangement 
for  the  equalization  of  reserves  was  effected  that  a  clearing- 
house rule  would  be  adopted  forbidding  the  payment  of  interest 
on  bankers'  deposits.  The  banks  were  almost  unanimously 
agreed  to  abolish  this  practice  which  had  so  seriously  hampered 
the  efforts  of  the  New  York  banks  to  maintain  specie  payment 
in  time  of  crisis;  but  by  the  refusal  of  a  few  members  to  accede, 
it  failed  to  become  a  binding  obligation.  In  1873  it  was  found 
that  twelve  of  the  clearing-house  banks  were  offering  this 
inducement  to  attract  deposits  and  were  thereby  securing  the 
great  majority  of  country-bank  balances.  When  the  crisis 
came,  the  strain  immediately  proved  heaviest  upon  these  banks, 
because  of  the  large  shipments  of  currency  tp  the  ipterior  that 


536  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

were  required.  When  reserves  were  equalized,  the  non-interest- 
paying  banks  found  themselves  contributing  their  cash  reserves 
to  the  support  of  these  twelve  institutions  which  had  not  resisted 
the  temptation  to  secure  the  profits  obtainable  from  the  practice 
of  attracting  interior  funds  to  New  York.  Such  a  situation  was 
of  course  not  calculated  to  promote  general  good  feeUng  on  the 
part  of  the  non-interest-paying  banks. 

There  were  other  difficulties  in  the  administration  of  the 
system  which  also  tended  to  promote  dissatisfaction.  "It 
was  believed,  and  doubtless  with  reason,  that  some  of  the 
banks  had  evaded  the  obligations  of  the  pooling  agreements. 
....  Further,  as  the  arrangement  had  not  included  bank 
notes,  banks  exchanged  greenbacks  for  notes  in  order  either  to 
increase  their  holdings  of  cash,  or  to  secure  mohey  for  payment 
over  the  counter."' 

The  results  of  this  experience  so  embittered  many  of  the 
banks  that,  when  in  1884  clearing-house  loan  certificates  were 
resorted  to,  there  was  immediately  a  powerful  opposition  to 
the  equalization  of  reserves.  "In  the  course  of  time, "  Professor 
Sprague  tells  us,  "all  recollection  of  the  arrangement  for  the 
equalization  of  reserves  seems  to  have  faded  from  the  memory 
of  the  banking  community. "  We  have  already  indicated  that 
the  use  of  the  clearing-house  loan  certificate  does  not  effect  a 
thoroughgoing  redistribution  of  banking  reserves;  and  when 
it  is  resorted  to  by  all  banks  simultaneously  it  only  maintains 
the  status  quo,  preventing  banks  from  weakening  each  other, 
but  efifectually  debarring  them  from  rendering  positive  mutual 
assistance.  The  clearing-house  banks  have  all  come  to  adopt 
the  use  of  clearing-house  loan  certificates  simultaneously  and 
in  the  relatively  early  stages  of  'a  crisis.  It  will  be  readily 
seen  that  this  practice  renders  their  use  largely  ineffective. 
After  a  thorough  study  of  all  the  panics  that  occurred  under  the 
national  banking  system,  Professor  Sprague  concludes  "that 
the  arrangement  for  equalizing  the  reserves,  adopted  in  1873, 
would  have  availed  to  prevent  suspension  on  subsequent 
occasions  is  highly  probable,  indeed,  a  practical  certainty." 

'  O.  M.  W.  Sprague,  Quarterly  Journal  of  Economics,  XXIV,  232. 


COMMERCLVL  BANKING  AND  BUSINESS  CYCLES      537 

Whether  this  estimate  of  the  potency  of  the  system  as  originally 
worked  out  to  prevent  the  suspension  of  specie  payments  and 
the  worst  phases  of  the  financial  collapse  is  correct  or  not,  it  is 
certainly  clear  that  the  simultaneous  resort  to  the  clearing-house 
loan  certificates  without  an  attempt  at  the  equalization  of 
reserves  could  not  in  the  nature  of  things  prevent  a  credit 
collapse  in  a  period  of  acute  strain. 

This  experience  of  the  banks  of  New  York  furnishes  another 
illustration  of  the.  way  in  which  the  commercial  banks  are 
inextricably  involved  in  a  system;  it  shows  that  no  individual 
banker  can  entirely  save  himself  or  his  customers  in  time  of 
emergency,  no  matter  how  sure  his  vision  or  how  careful  his 
management.  Bankers  as  a  group — and  with  them  business 
as  a  whole — must  stand  or  fall  together.  It  required  well 
over  a  century  of  banking  in  this  country,  however,  for  this 
truth  to  be  driven  home  with  sufl5cient  force  to  secure  a 
reorganization  of  our  banking  laws  in  such  a  way  as  to  make 
possible  the  control  of  individual  banking  activities  in  the 
interest  of  banking  and  business  welfare  as  a  whole.  The 
history  of  this  attempt  on  the  part  of  the  banks  to  secure 
co-operative  control  of  credit  in  times  of  emergency,  moreover, 
throws  no  little  light  upon  the  nature  of  and  difficulties  involved 
in  the  general  problems  of  organization  and  control  through 
private  initiative  under  modern  financial  and  industrial 
conditions. 

Various  substitute  forms  of  currency  are  resorted  to  in  time  of 
panic.  We  have  already  seen  that  after  the  outbreak  of  a 
panic  and  the  suspension  of  specie  payments  there  is  a  **  cur- 
rency famine."  It  is  impossible  for  individuals  with  deposit 
accounts  to  withdraw  the  funds  in  the  form  of  cash,  and  since, 
for  the  time,  these  bank  deposit  accounts  are  not  redeemable 
in  specie,  checks  drawn  against  them  will  not  be  honored. 
The  entire  credit  structure  by  means  of  which  the  overwhelming 
majority  of  our  exchange  transactions  are  effected  is  in  tempo- 
rary disintegration.  With  ordinary  money  unobtainable,  and 
with  the  deposit  system  temporarily  demoralized,  it  becomes 
necessary  to  conduct  such  business  operations  as  are  conducted 


538  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

with  substitute  forms  of  currency.  In  1907,  for  instance, 
the  banks  of  about  two-thirds  of  our  cities  having  more  than 
twenty-five  thousand  population  suspended  cash  payments  in 
whole  or  in  part.  Many  different  types  of  substitute  currency 
have  been  distinguished,  the  most  common  of  which  are  clearing- 
house loan  certificates,  clearing-house  checks,  cashier's  checks 
payable  only  through  the  clearing-house,  and  customer's 
checks  marked  ''Payable  only  through  the  clearing-house." 

The  clearing-house  loan  certificates  were  most  commonly 
used,  as  already  indicated,  in  settling  balances  between  banks. 
To  some  extent,  however,  they  were  issued  in  denominations 
convenient  for  use  in  paying  bank  depositors.  This  was 
particularly  the  case  in  the  panic  of  1907.  These  small- 
denomination  clearing-house  loan  certificates  were  secured  by 
collateral  deposited  with  the  clearing-house  committee,  and 
were  in  effect  guaranteed  by  all  the  associated  banks,  inas- 
much as  all  banks  in  the  clearing-house  agreed  to  accept  them 
at  par. 

The  clearing-house  checks  differed  from  clearing-house 
loan  certificates  only  in  form.  They  were  issued  by  the  clearing- 
house associations  to  member  banks  upon  deposit  of  approved 
collateral,  and  they  were  payable  only  through  the  clearing- 
house; but,  instead  of  being  a  promise  to  pay  by  the  clearing- 
house association,  they  were  in  the  form  of  checks  on  particular 
banks  and  were  signed  by  the  manager  of  the  clearing-house. 
Any  bank  in  Chicago,  for  instance,  desiring  to  issue  clearing- 
house checks  merely  deposited  the  corresponding  amount  of 
clearing-house  loan  certificates  of  large  denominations  and 
received  these  checks  in  convenient  size  for  general  use.  In 
effect  they  were  checks  secured  by  the  clearing-house  loan 
certificates,  which  in  turn  were  secured  by  the  collateral  depos- 
ited with  the  clearing-house. 

Many  national  banks  also  issued  cashier's  checks  in  small 
denominations  which  were  in  effect  substitute  forms  of  bank 
notes.  These  checks  commonly  read  "Pay  to  bearer,"  but  in 
fact  they  were  payable  only  through  the  clearing-house.  Some- 
times such  checks  were  unsecured  ^d  sometimes  they  were 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES      539 

backed  by  special  deposits  of  collateral  with  the  committee  of 
the  clearing-house. 

Checks  against  customers'  deposit  accounts  "made  payable 
only  through  the  clearing-house"  were  mainly  "pay  checks" 
drawn  by  large  concerns  as  a  means  of  meeting  their  pay-roUs. 
They  differed  from  other  forms  of  currency  in  that  they  were 
the  liability  neither  of  the  clearing-house  nor  of  the  banks  upon 
which  they  were  drawn,  but  only  of  the  corporation  for  whose 
benefit  they  were  issued.  These  pay  checks  were  issued  "by 
railroads,  mining  companies,  manufacturers,  and  storekeepers 
in  a  large  number  of  cities.  Shops  and  stores  and  places  of 
amusement  in  the  neighborhood  of  their  issue  generally  accepted 
them  and  it  is  indeed  surprising,  considering  their  variety, 
their  liability  to  counterfeit,  and  their  general  lack  of  security, 
how  little  real  difficulty  was  experienced  in  getting  them  to 
circulate  in  lieu  of  cash." 

It  may  be  added  here  that  these  substitute  forms  of  cur- 
rency are  retired  from  circulation  as  soon  as  the  banks  resume 
specie  pa3niients,  usually  a  matter  of  a  few  weeks  or  months 
only,  during  which  time  the  process  of  financial  liquidation  has 
run  its  vicious  course  and  the  demand  for  bank  accommodations 
has  decUned  to  the  low  level  which  characterizes  the  period  of 
business  depression.  A  tax  upon  these  irregular  forms  of 
currency  expedites  their  return  to  the  banks  when  the  active 
need  for  them  has  passed. 

While  the  panic  stage  of  the  business  cycle  may  he  eliminated, 
the  ebb  and  flow  of  business  activity  and  the  recurring  periods  of 
acute  financial  strain  can  at  best  only  be  minimized.  In  the  fore- 
going discussion  of  the  stage  of  acute  crisis  the  impression  may 
have  been  given  that  the  eventuation  of  crises  into  panics 
has  characteristically  been  largely  accidental — that  if  a  certain 
bank  failure  had  not  occurred  under  certain  precise  circimi- 
stances,  that  if  the  banks  had  postponed  for  a  longer  period 
the  suspension  of  specie  payments,  that  if  people  did  not 
become  unduly  excited  and  hoard  currency,  that  if  the  com- 
mercial banks  and  other  financial  institutions  did  not  them- 
selves join  in  the  mad  scramble  for  cash,  panics  would  not 


540  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

have  resulted.  It  is  always  true,  in  fact,  that  the  beginning 
of  the  end  is  marked  by  some  particular  event  which  it  would 
appear  might  have  been  avoided.  But  the  statement  of  this 
fact  must  not  lead  us  to  forget  that  there  are  always  certain 
fundamental  conditions  which  precipitate  these  striking  indi- 
vidual events,  and  that  if  the  panic  had  not  been  occasioned  by 
the  failure  of  the  Knickerbocker  Trust  Company,  it  might  well 
have  been  caused  shortly  by  the  failure  of  some  other  bank  or 
trust  company — a  failvire  brought  about  by  the  fundamental 
weakness  of  the  banking  credit  structure  at  such  a  time. 

This  is  not  to  say,  however,  that  the  match  which  pre- 
cipitates the  conflagration  must  perforce  always  be  touched  off. 
There  have  been  occasions,  in  fact,  when,  had  events  taken  a 
slightly  different  course,  some  of  the  periods  of  acute  strain 
which  were  passed  without  the  suspension  of  specie  payments 
might  have  resulted  in  complete  panic.  Nor  is  it  intended  to 
argue  that  the  panic  stage  of  the  business  cycle  may  not  be 
permanently  eliminated;  it  is  believed,  however,  that,  if  the 
upward  swing  of  the  business  cycle  is  allowed  to  continue  to  a 
point  where  bank  reserves  are  exhausted,  and  if  there  does 
not  reside  in  the  banking  system  a  means  of  then  expanding 
temporarily  the  volume  of  loanable  funds,  a  great  many  business 
failures  and  a  very  complete  derangement  of  the  entire  economic 
and  financial  structure  is  inevitable.  Granted  that  specie 
payments  were  not  suspended  as  between  the  banks,  and  granted 
that  the  banks  did  not  scramble  for  each  other's  reserves,  and 
that  in  consequence  they  were  enabled  to  restrict  the  quantity 
of  credit,  it  would  still  remain  true  that  the  industrial  and 
financial  situation  would  be  extremely  serious.  For  unle^ 
loans  can  be  expanded,  with  which  to  meet  the  inordinate 
demand  for  funds  required  to  tide  business  over  the  period 
of  crisis,  there  must  be  a  general  crumbling  of  the  complicated 
credit  structure,  entailing  a  great  number  of  failures  and 
enormous  losses  to  business  generally. 

And  as  we  shall  later  see,  even  where  the  banking  system 
is  so  constructed  as  to  make  possible  a  rapid  expansion  of  loans 
in  time  of  crisis,  it  is  still  impossible  to  eliminate  a  period  of 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES       541 

serious  industrial  readjustment  involving  many  failures  and 
accompanying  losses.  For  the  underlying  conditions  which 
have  narrowed  margins  of  profit  and  produced  the  strains  and 
stresses  in  the  economic  and  financial  structure  and  precipitated 
the  period  of  crisis  cannot  be  eliminated  without  an  intervening 
period  of  liquidation — which  means  concretely  the  elimination 
of  poorly  managed,  poorly  located,  or  poorly  equipped  establish- 
ments, readjustment  in  the  volume  of  output  on  the  part  of 
practically  all  business,  falling  interest  rates  and  declining  prices 
and  wages.  The  problem  of  control,  therefore,  is  not  one  of 
eliminating  the  business  cycle — except  the  panic  stage — ^for  this 
is  impossible,  as  we  have  seen,  under  a  profit-making,  competi- 
tive industrial  system.  The  problem  is  rather  one  of  mini- 
mizing the  extremes  of  fluctuations  that  occm-  and  thereby 
reducing  as  far  as  possible  the  social  losses  that  are  entailed. 
The  chapter  on  the  Federal  Reserve  System  outlines  the 
mechanism  that  has  been  evolved  in  the  United  States  for  thus 
controlling  the  credit  system. 


QUESTIONS  FOR  DISCUSSION 

I.      SEASONAL  VARIATIONS  IN  THE  DEMAND  FOR  FUNDS 

1.  Using  the  material  on  pages  495-97,  draw  a  diagram  indicating 
the  seasonal  variations  in  the  demand  for  funds  in  the  New  York 
and  Chicago  money  markets. 

2.  What  coincidence  of  business  events  occasions  the  extraordinary 
demands  of  the  autumn  season  ? 

3.  Does  the  chart  on  page  498  indicate  that  the  total  supply  of 
available  currency  is  always  employed,  in  speculative  if  not  in 
ordinary  business  uses  ? 

4.  What  conclusions  do  you  arrive  at  from  a  study  of  the  chart  on 
page  499  ? 

5.  Wliat  is  meant  by  the  term  "elastic  currency"? 

6.  Is  their  any  elasticity  in  the  following  forms  of  our  currency: 
(o)  greenbacks;  (b)  treasury  notes  of  1890;  (c)  sUver  dollars; 
(<i)  sUver  certificates;  (e)  gold  certificates;  (/)  gold?  What 
factors  govern  the  total  amount  of  gold  that  any  coimty  army 
have  ? 


542         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

7.  To  what  forms  of  currency  must  we  look  to  give  the  necessary 
elasticity  to  the  system  ? 

8.  What  does  the  chart  on  page  499  indicate  as  to  the  relative 
elasticity  of  bank  notes  and  deposits  ? 

9.  Explain  in  your  own  words  the  reasons  for  the  inelasticity  of 
bond-secured  bank  notes. 

10.  Explain  in  your  own  words  the  reasons  for  the  elasticity  of 
deposit  ourency. 

11.  What  are  the  limits  to  the  expansibility  of  deposit  cmrency? 
Why  cannot  it  be  relied  upon  to  meet  any  and  all  requirements 
of  the  autumn  season,  however  heavy  ? 

12.  Why  should  business  failures  be  more  numerous  in  periods  of 
tight  money  ?    Is  this  an  unmixed  evil  ? 

n.   THE  FEDERAL  TREASURY  AND  THE  CURRENCY  SUPPLY 

13.  What  determines  the  total  quantity  of  funds  in  the  Treasury 
at  any  time  ? 

14.  What  are  the  principal  sources  of  federal  taxation?  Do  they 
yield  a  steady  or  an  intermittent  revenue  ? 

15.  What  is  meant  by  the  "independent  treasury"? 

16.  Is  it  a  matter  of  any  importance  whether  the  Treasury  keeps  its 
funds  in  its  own  vaults  or  in  the  banks:  (a)  in  ordinary  times; 
(b)  in  times  of  seasonal  monetary  strain  ? 

17.  Do  you  see  any  reason  why  the  Treasury  should  not  keep  its 
funds  on  deposit  in  the  banks — ^and  in  such  particular  banks 
as  it  chooses  ? 

18.  Is  it  necessary  for  the  Treasury,  as  a  practical  proposition,  to 
maintain  at  all  times  a  considerable  cash  balance?  Consult 
the  financial  reports  made  by  the  Treasury  Department  from 
time  to  time  and  ascertain  how  large  a  balance  is  usually  on  hand. 

19.  Why  cannot  the  federal  Treasury  be  relied  upon  to  give  the 
necessary  elasticity  to  the  currency  system  ? 

m.   CYCEICAL  VARIATIONS  IN  THE  DEMAND  FOR  FUNDS 

20.  Define  the  following  terms:  (a)  cycle;  (6)  crisis;  (c)  panic. 

21.  Into  what  four  stages  may  the  economic  cycle  be  divided? 
What  are  their  relative  diurations?  Consult  historical  data  on 
pages  505-7. 

22.  According  to  Mitchell's  analysis,  what  factors  during  a  period  of 
depression  are  conducive  to  an  expansion  of  business  activity? 

23.  What  important  factor  is  ordinarily  lacking  at  such  a  period  ? 


Commercial  banking  and  business  cycles     543 

24.  What  fortuitous  events  hastened  the  recovery  of  business  in 
1897  and  1898? 

25.  Trace  the  effects  of  a  bountiful  harvest  in  accelerating  business 
throughout  the  industrial  field. 

26.  Trace  the  effects  of  a  business  boom  in  the  iron  and  steel  industry 
upon  other  lines  of  enterprise. 

27.  During  periods  of  depression  the  demand  for  labor  is  slack  and 
employment  in  many  lines  is  intermittent.  Trace  the  effects  of 
the  steady  employment  that  ret>dlts  from  the  return  of  prosperity 
upon  the  activity  of  business  in  general. 

28.  Would  you  say  that  the  increased  purchasing  power  of  labor  in 
general  is  due  mainly  to  increased  money  wages  or  to  steady 
employment  ? 

29.  The  upward  swing  of  the  business  cycle  may  be  divided  into  two 
periods:  first,  the  period  during  which  the  slack  is  being  taken 
up  and  the  existing  industrial  equipment  of  the  country  is  coming 
to  be  utilized  at  fuU  capacity;  second,  the  period  when,  in 
addition,  there  is  a  great  increase  in  building  activities — in  the 
construction  of  additional  capital  goods.  What  are  the  effects 
of  the  second  stage  upon:  (a)  the  demand  for  labor;  (b)  the 
demand  for  funds;  (c)  the  cost  of  conducting  business? 

30.  To  what  extent  do  you  think  that  psychology  plays  a  part  in 
the  rapid  expansion  of  business  ?  Would  you  say  that  business 
psychology  is  responsible  for  the  expansion  of  business,  or  that 
business  recovery  occasioned  by  some  fortuitous  event  breeds 
business  optimism  ?  What  is  it  that  converts  business  optimism 
into  business  pessimism  ? 

31.  What  causes  the  development  of  "stresses  and  strains"  in  the 
industrial  system  ?  Why  cannot  the  period  of  active  prosperity 
go  on  indefinitely  ? 

32.  Why  do  these  strains  appear  in  certain  lines  before  they  appear 
in  others  ? 

33.  Do  you  think  the  steadily  rising  prices  and  the  resulting  "high 
cost  of  Uving"  has  anything  to  do  with  the  precipitation  of  a 
critical  period  ? 

34.  "Costs  continue  to  rise,  and  with  increasing  rapidity,  as  the 
business  cycle  reaches  the  top  of  its  upward  swing.  This  would 
not,  however,  lessen  the  margins  of  profit  if  prices  were  raised 
proportionally. "  Why,  in  fact,  cannot  prices  be  proportionally 
advanced  indefinitely  ? 


544  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

IV.      COMMERCIAL  BANKING  AND  BUSINESS  CYCLES 

35-  What  bearing  has  the  condition  of  the  commercial  bank  reserves 
upon:  (a)  the  extent  to  which  prices  may  rise;  (b)  the  volume  of 
business  that  may  be  conducted  ? 

36.  Would  you  say  that  the  supply  of  available  funds  in  a  commercia 
bank  has  anything  to  do  with  the  difficulties  that  early  beset 
the  construction  industries  ?    If  so,  how  ? 

37.  The  crisis  stage  may  be  divided  into  two  parts:  (a)  the  critical 
period  extending  over  a  year  or  so;  (b)  the  period  of  acute  tension 
immediately  preceding  the  panic.  During  this  critical  period* 
why  is  it  that  business  men  do  not  commonly  heed  the  warning 
signs  that  are  in  evidence  ? 

38.  Under  our  national  banking  system  as  organized  before  19 14, 
why  did  not  the  banks  heed  the  warning  signs  and  exercise  their 
control  over  the  money  supply  in  such  a  way  as  to  compel  a 
readjustment  of  business  ? 

39.  Do  you  think  that  bankers  as  a  group  share  the  general  optimism 
that  pervades  the  industrial  world  during  a  period  of  great 
prosperity  ? 

40.  In  the  period  of  acute  financial  tension,  immediately  preceding 
the  panic,  what  responsibility  is  placed  uf>on  the  commercial 
banks? 

41.  "The  process  by  which  all  the  banks  at  once  are  trying  to 
strengthen  their  reserves  is  an  altogether  impossible  process,  a 
paradox,  a  deathblow  at  the  very  fundamental  principle  of 
banking.  Any  general  attempt  to  convert  banking  paper  or 
deposit  credit  into  gold  must  promptly  issue  in  a  lamentable 

collapse  of  the  whole  credit  machinery When  the  banks 

themselves  join  in  the  scramble,  the  last  hope  of  supporting  the 
credit  fabric  has  vanished. "    Why  ? 

42-  Assume  a  bank  in  New  York  to  have  deposits  of  $1,000,000, 
with  a  reserve  of  $275,000,  or  27.5  per  cent.  Assume  (a)  that 
additional  loans  are  made  to  the  extent  of  $100,000,  and  (b)  that 
depositors  withdraw  $50,000  in  actual  specie.  What  is,  then, 
the  ratio  of  reserves  to  deposits  ? 

43.  "In  times  of  crises  we  have  it  clearly  revealed  to  us  that  our 
banking  institutions  constitute  a  system,  and  that  individual 
banL-%  Ciinnr't  procur«i  much  aid  from  each  other."  In  what 
way? 


COMMERCIAL  BANKING  AND  BUSINESS  CYCLES      545 

44.  Turn  to  the  financial  statements  on  pages  364-66  and  indicate 
what  assets  could  be  converted  into  cash  in  time  of  acute  financial 
tension  ? 

45.  At  such  a  period  are  the  loans  made  to  individuals  who  are 
engaged  in  actual  commercial  operations  automatically  liquidated 
as  they  mature  ? 

46.  Can  the  banks  as  a  whole  count  upon  having  as  many  loans  paid 
as  there  are  demands  for  new  loans  ? 

47.  Why  could  the  national  bank  notes  not  be  readily  increased  in 
volume  ? 

48.  Why  could  not  the  deposit  currency  be  increased  in  volume? 

49.  "The  fundamental  need  in  times  of  crises  is  an  increase  in  cash 
resources  on  the  basis  of  which  additional  loans  may  be  granted. " 
Why? 

50.  Why  was  it  not  possible  for  our  banks  before  the  estabUshment 
of  the  Federal  Reserve  System  to  increase  the  total  quantity  of 
cash  reserves?  What  factors,  in  fact,  served  to  decrease  the 
available  cash  resources  of  the  banks  ? 

51.  Explain  the  effects  of  the  system  of  redepositing  reserves  upon 
the  banks  in  time  of  crisis. 

52.  Why  were  the  banks  of  the  United  States  obliged  to  reduce  loans 
during  the  period  of  acute  crisis  ? 

53.  Explain  the  difference  between  the  equalization  of  reserves  and 
the  use  of  clearing-house  loan  certificates. 

54.  How  do  clearing-house  loan  certificates  differ  from  clearing-house 
certificates  ? 

55.  Why  was  the  provision  for  the  equalization  of  reserves  necessary 
to  the  successful  use  of  the  loan  certificate  ? 

56.  Why  could  not  the  practice  of  paying  interest  on  deposits  be- 
eliminated  by  clearing-house  action  ? 

57.  Do  you  find  in  the  history  of  this  attempt  to  pool  banking 
reserves  a  weakness  inherent  in  the  system  of  independent 
banking  ? 

58.  Why  is  it  that  the  resort  to  clearing-house  loan  certificates  by 
aU  the  banks  simultaneously — unaccompanied  by  the  equalizing 
of  reserves — largely  defeats  the  purpose  of  this  expedient  ? 

59.  At  best,  would  the  use  of  clearing-house  loan  certificates,  with 
equalized  reserves,  reach  the  heart  of  the  difficulty  in  time  of 
crisis  ?    Why,  or  why  not  ? 


546  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

60.  Do  you  regard  the  various  forms  of  clearing-house  loan  certifi- 
cates and  checks  used  in  time  of  crisis  as  amply  secured  ? 

61.  It  is  sometimes  said  that  the  great  need  in  time  of  crisis  is  for 
more  currency  that  will  circulate  from  hand  to  hand,  and  that 
the  resort  to  clearing-house  loan  certificates  is  proof  of  this 
contention.     Do  you  agree  ? 

62.  For  which  is  there  a  greater  need  in  time  of  crisis,  an  expansion  of 
deposit  ourency,  or  an  expansion  of  bank-note  currency  ? 

REFERENCES  FOR  FURTHER  STUDY 

Agger,  Eugene  E.:  Organized  Banking,  chaps,  iv  and  v. 

Holdsworth,  John  Thom:  Money  and  Banking,  chap.  xxi. 

Laughlin,  J.  Laurence:  Banking  Progress,  chaps,  ii,  iii,  and  vii. 

Mitchell,  Wesley  C. :  Business  Cycles,  Parts  I  and  III. 

Moulton,  Harold  G.:  Principles  of  Money  and  Banking,  pp. 
123-92. 

Persons,  Warren  M.:  In  The  Review  of  Economic  Statistics, 
Harvard  University  Committee  on  Economic  Research.    April,  1919. 

Phillips,  Chester  A.:  Readings  in  Money  and  Banking,  chaps, 
xxix,  XXX. 

Sprague,  O.  M.  W.:  Crises  under  the  National  Banking  System 
(National  Monetary  Commission,  1910). 

White,  Horace:  Money  and  Banking,  Book  III,  chap,  xviii. 


CHAPTER  XXIV 

GOVERNMENT  REGULATION  OF  BANKING 

Commercial  banking  was  one  of  the  earliest  forms  of 
business  to  be  subjected  to  governmental  regulation.  Because 
of  the  almost  imiversal  demand  for  the  accommodation  which 
banking  affords,  and  because  of  the  tremendous  power  that  is 
inherent  in  the  control  of  loanable  funds,  the  banking  business 
has  long  been  regarded  as  quasi-public  in  its  nature.  Indeed, 
many  people  have  asserted  that  banking  operations  are  of 
such  importance  to  the  public  welfare  that  they  should  be 
actually  conducted  by  the  government  itself;  that  to  permit 
private  interests  to  control  the  supply  of  bank  currency  and 
make  profits  from  the  use  of  people's  money  is  to  foster  one 
of  the  most  vicious  of  monopolies.  This  extreme  view  has, 
however,  never  gained  general  acceptance;  nor  imtil  recently 
have  we,  in  fact,  subjected  all  banks  in  the  United  States  to 
some  species  of  governmental  control.  Indeed,  in  some  states 
it  is  still  possible  for  individuals  to  engage  in  a  general  banking 
business  subject  virtually  to  no  regulation  whatever,  although 
the  numerous  disastrous  failures  of  private  banks  in  recent 
years  have  led  to  an  agitation  against  unregulated  banking 
which  promises  shortly  to  result  in  its  complete  elimination. 

It  is  the  purpose  of  the  present  chapter  to  outline  the 
various  regulations  that  are  commonly  imposed  upon  national 
and  state  banks,  and  to  present  the  reasons  for  such  regulations. 
The  discussion  must  of  necessity  be  confined  to  the  more  sig- 
nificant aspects  of  such  regulation;  detailed  provisions  of  the 
laws  and  of  administrative  decisions  will  be  omitted. 

L    SUMMARY  OF  AMERICAN  BANKING  HISTORY 

While  each  of  the  main  principles  of  regulation  may  best  be 
presented  as  a  separate  problem  and  considered  in  the  light  of 
its  particular  history,  a  brief  preliminary  statement  of  the 

?4r 


548  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

history  of  banking  regulation  in  the  United  States  will  serve 
as  a  useful  point  of  departure.  This  history  may  be  con- 
veniently divided  into  three  stages:  (i)  from  1790  to  the  Civil 
War;  (2)  from  the  Civil  War  to  the  adoption  of  the  Federal 
Reserve  System  in  1914;  and  (3)  from  1914  to  the  present 
time. 

In  the  period  before  the  Civil  War  banking  operations  in  the 
United  States  were  mainly  conducted  either  by  private  bankers 
or  by  institutions  chartered  under  state  laws.  During  this 
period  there  were  no  national  banks  chartered  for  the  express 
purpose  of  engaging  in  general  banking  operations,  although  the 
First  Bank  of  the  United  States  (1791-1811)  and  the  Second 
Bank  of  the  United  States  (1816-36)  did  make  some  loans  for 
business  purposes.  The  history  of  these  federal  banks  will 
presently  be  considered. 

During  the  pre-Civil  War  period  the  banking  laws  of  the 
various  states  were  extremely  diverse  and,  with  a  few  exceptions, 
notably  in  New  England  and  New  York,  extraordinarily  lax. 
In  consequence  the  management  of  the  state  banks  was  usually 
no  better  than  that  of  the  private  institutions  which  flourished 
at  the  time.  While  improvements  were  being  made  in  the 
latter  part  of  the  period,  banking  organization,  on  the  whole, 
remained  in  a  deplorable  condition  until  after  the  Civil  War. 

The  National  Bank  Act  passed  in  1863  provided  for  the 
incorporation  of  national  institutions  under  the  general  super- 
vision of  a  Comptroller  of  the  Currency.  These  institutions 
were  designed  to  engage  in  general  banking  operations  and  to 
supplant  the  state  banks  in  the  issue  of  bank-note  currency.' 
The  framers  of  the  law  profited  much  from  previous  state 
banking  experience  and  many  admirable  principles  for  the 
regulation  of  banking  operations  were  formulated.  These 
will  be  outlined  in  the  pages  which  follow. 

Under  the  stress  of  competition,  and  in  the  light  of  improved 
knowledge  of  sound  banking  organization,  the  laws  of  the 
various  states  have  gradually  been  remodeled  to  conform  more 

*  The  issue  of  state  bfink  notes  was  effectively  prevented  in  1866  by  the 
levy  of  a  10  per  cent  tax  on  all  notes  put  out  by  state  banks. 


GOVERNMENT  REGULATION  OF  BANKING  $49 

closely  with  the  provisions  of  the  national  law.*  The  changes 
in  general  banking  organization  and  control  that  have  been 
inaugurated  by  the  Federal  Reserve  System  are  discussed  in 
chapters  xxv  and  xxix. 

The  First  and  Second  Banks  of  the  United  States.  Only  a 
brief  statement  is  necessary  with  reference  to  the  work  of  these 
federal  banks.  The  purpose  of  their  organization  appears  to 
have  been  a  threefold  one:  (i)  to  act  as  fiscal  agent  of  the 
United  States  government  in  the  collection  and  disbursement 
of  federal  revenue;  (2)  to  assist  the  Treasury  in  times  of  finan- 
cial emergency,  through  the  purchase  of  government  bonds; 
(3)  to  promote  a  sounder  and  more  stable  bank-note  currency 
and  to  exercise  an  influence  in  stabilizing  business  and  financial 
conditions  generally. 

The  First  Bank  of  the  United  States  performed  a  genuinely 
important  service  during  the  first  twenty  years  of  our  national 
history.  It  acted  as  fiscal  agent  in  the  collection  and  disburse- 
ment of  government  funds  at  a  time  when  the  problems  involved 
were  particularly  difficult  because  of  inadequate  private  finan- 
cial facilities.  The  First  Bank  also  loaned  several  million 
dollars  to  the  government  during  a  period  when  federal  revenue 
was  both  uncertain  in  amount  and  intermittently  received. 
The  bank  did  not,  however,  exert  any  great  influence  on  the 
general  currency  and  credit  system.  The  charter  expired  in 
181 1  and  failed  of  renewal  by  a  single  vote  in  the  Senate. 

The  Second  Bank  of  the  United  States  had  a  very  checkered 
career.  It  was  very  badly  managed  during  the  first  few  years 
of  its  history;  it  extended  credit  with  abandon  and  failed  to 
maintain  adequate  specie  reserves.  It  exerted  no  restraining 
influence  upon  the  activities  of  the  state  banks,  and  on  the 
whole  it  exercised  an  unfavorable,  rather  than  a  favorable, 
influence  during  the  boom  period  and  crisis  of  181 7-19.  In 
the  decade  of  the  twenties,  however,  the  Second  Bank  appears 

'  There  are  some  exceptions  to  this  general  statement,  however,  the 
chief  of  which  is  that  the  prohibition  of  the  federal  law  against  loans  on 
real  estate  was  not  copied  by  the  state  laws.  On  the  contrary,  the  Federal 
Reserve  Act  authorized  certain  national  banks,  within  limits,  to  engage  in 
real  estate  loaning.    See  p.  554. 


55©  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

to  have  been  competently  managed  and  of  genuine  assistance 
in  conducting  the  fiscal  operations  of  the  government.  More- 
over, in  the  critical  year  1826  the  bank  was  in  a  position  to 
exert  some  influence  in  stabilizing  business  conditions.  It  never 
accomplished  much,  however,  in  the  way  of  securing  a  more 
stable  bank-note  currency. 

With  the  accession  to  power  of  President  Jackson,  in  1829, 
owing  to  a  combination  of  circumstances,  the  Second  Bank 
became  a  political  issue.  From  this  time  on,  the  management 
of  the  institution  deteriorated,  and  its  usefulness  was  seriously 
unpaired;  and  when  in  1833  President  Jackson  ordered  the 
withdrawal  of  federal  deposits  from  the  bank,  its  fate  was 
virtually  sealed.  The  charter  was  not  renewed  in  1836;  and 
from  then  until  1863  the  United  States  was  without  any  national 
banking  institution.  The  later  unfortunate  history  of  the 
Second  Bank  is  attributable  not  to  any  inherent  defects  in 
the  bank  itself,  but  rather  to  the  exigencies  of  an  era  during 
which  the  doctrine  that  the  centralization  of  political  and 
financial  power  was  essentially  undemocratic  was  in  the 
ascendancy. 

II.    PRINCIPLES    OF    GOVERNMENTAL 
REGULATION 

Governmental  regulation  of  banking  is  accomplished  in 
several  ways:  (i)  by  supervising  the  original  organization; 
(2)  by  prohibiting  certain  types  of  loans;  (3)  by  requiring  the 
maintenance  of  adequate  specie  reserves;  and  (4)  by  a  system 
of  bank  examinations  and  reports.  We  may  consider  the 
reasons  for  each  type  of  regulation. 

I.  Supervising  the  original  organization.  Discussion  of  the 
reasobs  for  governmental  supervision  of  the  initial  organization 
of  banks  raises  at  once  the  whole  issue  of  private  versus  regu- 
lated banking.  The  argument  against  private  banking  is, 
in  brief,  that  although  many  unincorporated  banks  might 
conduct  their  banking  operations  on  the  most  approved  prin- 
ciples, many  others  might  not — with  resulting  disastrous  con- 
sequences to  depositors.     The  contention  that  in  the  long  run 


GOVERNMENT  REGULATION  OF  BANKING  551 

honesty  and  efficiency  in  bank  management  constitute  the  best 
policy  is  hardly  a  sufficient  argument  for  permitting  private 
banking,  for  the  reason  that  so  many  people,  unfortunately, 
consider  that  one  bank  is  as  good  as  another,  regardless  of 
antecedents  and  character  of  management.  That  depositors 
are  in  need  of  protection  from  inefficient  and  unscrupulous 
bankers  is  abundantly  evident  from  the  numerous  cases  of 
private  bank  failures  in  recent  years,  where  disclosures  have 
shown  that  the  deposits  of  customers  had  been  either  con- 
fiscated outright  or  diverted  to  such  speculative  enterprises  as 
to  make  practically  certain  the  inability  of  the  bank  to  meet  its 
obligations.  The  incorporation  of  a  bank,  and  the  necessary 
conformity  with  general  laws  that  this  involves,  does  much  to 
insure  at  least  a  minimmn  of  honesty  and  efficiency  in  the 
conduct  of  the  institution. 

A  statement  of  the  causes  of  national  bank  failures  will 
throw  some  light  upon  the  necessity  for  restrictions  upon 
banking  operations,  as  well  as  for  the  system  of  bank  exami-- 
nations,  to  be  discussed  below.  An  investigation  made  by 
the  Comptroller  of  the  Currency  in  191 1  shows  that  60  per 
cent  of  the  failures  of  national  banks  were  caused  by  violations 
of  the  National  Banking  Law,  37  per  cent  of  which  were  criminal 
violations.  Twenty- three  per  cent  were  caused  by  "injudi- 
cious" banking,  13  per  cent  by  shrinkage  in  values  and  general 
stringency  in  the  money  market;  while  4  per  cent  resulted  from 
the  failure  of  large  debtors  and  other  minor  causes. 

Banks  nowadays  commonly  take  out  their  charters  under  a 
general  incorporation  law,  although  formerly  incorporation 
under  a  special  act  of  the  legislature  was  required.  The  prin- 
ciple underlying  special  incorporation  is  that  it  permits  each 
application  for  a  bank  charter  to  be  considered  by  the 
legislature  strictly  on  its  merits.  It  transpired  in  practice, 
however,  that  the  granting  of  charters  to  engage  in  banking 
commonly  became  a  part  of  the  political  spoils  system.  "  Char- 
ters were  granted  by  Whig  and  Democratic  legislatures  only 
to  their  own  partisans  ....  and  shares  in  banks,  or  the 
rights  to  subscribe  to  them,  were  parcelled  out  by  'bosses'  in 


552  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  several  counties."  The  reaction  from  this  system  even- 
tually led  to  the  establishment  of  a  general  incorporation,  or 
"free  banking, "  law  in  the  state  of  New  York  in  1838.  Under 
this  free  banking  system  any  group  of  individuals  who  desired  to 
engage  in  the  banking  business  might  be  granted  a  charter  for 
the  purpose  by  the  administrative  branch  of  the  state  govern- 
ment, provided  there  was  assurance  that  the  bank  would  be 
organized  and  conducted  in  accordance  with  certain  general 
requirements  laid  down  by  an  act  of  the  legislature. 

This  system  of  incorporation  was  very  generally  followed 
by  the  western  states  during  the  decade  immediately  preceding 
the  Civil  War;  and  in  the  National  Bank  Act  of  1863  it  was 
adopted  as  an  essential  part  of  the  national  banking  system. 
It  has  since  been  gradually  copied  by  all  of  the  state  govern- 
ments, the  time  involved  in  making  legislative  investi- 
gations as  a  prerequisite  to  the  granting  of  a  charter  having 
proved  quite  as  important  a  factor  in  the  drift  toward  general 
incorporation  as  have  the  political  evils  of  the  special-charter 
system. 

The  principal  advantage  of  requiring  the  incorporation  of 
banks  is  that  it  makes  it  possible  for  the  government  to  control 
the  size  of  banking  institutions.  The  National  Bank  Act,  as 
amended,  for  instance,  lays  down  the  following  regulations 
with  reference  to  the  minimum  capital  requirements  for  national 
banks:  in  cities  of  more  than  fifty  thousand  population,  a 
capital  of  not  less  than  $200,000;  of  from  six  to  fifty  thousand, 
inhabitants,  a  minimum  capital  of  $100,000;  of  from  three  to 
six  thousand  inhabitants,  a  capital  of  at  least  $50,000;  and  in 
towns  up  to  three  thousand  population,  a  minimum  capital  of 
$25,000.  The  purpose  of  these  capital  requirements  is  to 
prevent  the  organization  of  a  large  number  of  very  small  banks, 
which  in  the  nature  of  things  would  usually  be  less  efficiently 
managed,  and  which  would  be  certain  to  have  a  less  extensive 
distribution  of  risks  than  banks  of  larger  size. 

Stockholders  of  banks  are  subjected  to  a  double  liability. 
The  stockholders  of  every  national  bank  are  held  individually 
responsible  "for  all  contracts,  debts,  and  engagements  of  such 


GOVERNMENT  REGULATION  OF  BANKING  553 

association,  each  to  the  amount  of  his  stock  therein,  at  the  par 
value  thereof,  in  addition  to  the  amount  invested  in  such  stock"; 
and  similar  provisions  are  found  in  the  banking  laws  of  all  the 
states.  The  purpose  of  this  double  Uability  of  shareholders 
is  to  give  an  ampler  protection  to  creditors  of  banking  insti- 
tutions than  is  afforded  by  the  strictly  limited  liability  principle. 
The  quasi-public,  nature  of  banking  institutions,  which  serve 
as  repositories  for  the  cash  resources  of  all  classes  of  people, 
warrants  these  extra  precautions  for  the  safety  of  depositors. 

The  capital  stock  must  he  fully  subscribed.  Another  provision 
of  the  national  banking  law  is  that  the  capital  shall  be  fully 
paid  in  before  business  is  started.  The  explanation  of  this 
provision  is  foumd  in  state  banking  experience  before  the  Civil 
War.  The  early  state  banking  laws  permitted  banks  to  com- 
mence operations  as  soon  as  a  small  portion  of  the  capital  stock 
had  been  actually  subscribed  in  cash,  the  rest  of  the  capital 
usually  being  represented  by  promissory  notes  of  the  stock- 
holders. It  was  made  to  appear  to  depositors  that  the  capital 
was  really  paid  in  and  represented  genuine  resoiurces  of  the 
bank;  but  when  failures  occurred,  the  true  situation  was  of 
course  immediately  disclosed. 

Accumulation  of  a  surplus  is  also  required.  The  National 
Bank  Act  provides  that  before  the  declaration  of  a  (semi- 
annual) dividend  each  bank  shall  "carry  one-tenth  part  of  its 
net  profits  of  the  preceding  half-year  to  its  surplus  fund  until 
the  same  shall  amount  to  20  per  centum  of  its  capital  stock." 
The  purpose  of  this  provision  is  to  make  sure  that  national  banks 
shall  gradually  increase  in  size;  for  it  is  believed  that  the 
larger  a  bank's  resources,  the  greater  is  the  security  of  its 
creditors.* 

2.  The  regulation  of  loans.  Since  the  chief  source  of  bank 
losses,  aside  from  defalcations,  lies  in  the  failure  of  bank  bor- 
rowers to  meet  their  obligations,  it  has  been  found  expedient  to 
place  certain  restrictions  upon  the  lending  operations  of  the 

'There  is,  however,  some  confusion  of  thought  underlying  this  pro- 
vision. See  the  author's  "The  Surplus  in  Commercial  Banking,"  Journal 
of  Political  Economy,  December,  191 7. 


554  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

banks.  The  provisions  of  the  national  banking  law  governing 
loaning  operations  are  the  result  of  previous  banking  experience 
which  showed  that  certain  types  of  lending  operations  were 
fraught  with  special  danger.  The  loan  provisions  of  the 
National  Bank  Act,  as  amended,  are  as  follows: 

a)  It  shall  be  lawful  for  any  such  (banking)  association  to 
purchase,  hold,  and  convey  real  estate  as  follows » 

First.  Such  as  shall  be  necessary  for  its  immediate  accommo- 
dation in  the  transaction  of  its  business. 

Second.  Such  as  shall  be  mortgaged  to  it  in  good  faith  by  way 
of  security  for  debts  previously  contracted. 

Third.  Such  as  shall  be  conveyed  to  it  in  satisfaction  of  debts 
previously  contracted  in  the  course  of  its  dealings. 

Fourth.  Such  as  it  shall  purchase  at  sales  under  judgments, 
decrees,  or  mortgages  held  by  such  association,  or  shall  purchase  to 
secure  debts  due  to  said  association.  (National  Bank  Act,  June  3, 
1864.) 

Such  associations  shall  not  hold  the  possession  of  any  real  estate 
under  mortgage,  or  hold  the  title  and  possession  of  any  real  estate 
purchased  to  secure  any  debts  due  to  it  for  a  longer  period  than 
five  years.     (National  Bank  Act,  June  3,  1864.) 

"Any  national  banking  association  not  situated  in  a  central 
reserve  city  may  make  loans  secured  by  improved  and  unencumbered 
farm  land,  situated  within  its  federal  reserve  district,  but  no  such 
loan  shall  be  made  for  a  longer  time  than  five  years,  nor  for  an  amount 
exceeding  fifty  per  centum  of  the  actual  value  of  the  property  ofiFered 
as  security.  Any  such  association  may  make  such  loans  in  an 
aggregate  sum  equal  to  twenty-five  per  centum  of  its  capital  and 
surplus  or  to  one-third  of  its  time  deposits,  and  such  banks  may 
continue  hereafter  as  heretofore  to  receive  time  deposits  and  to 
pay  interest  on  the  same."     (Federal  Reserve  Act,  December  23, 

1913) 

The  Federal  Reserve  Board  shall  have  power  from  time  to  time 
to  add  to  the  list  of  cities  in  which  national  banks  shall  not  be  per- 
mitted to  make  loans  secured  upon  real  estate  in  the  manner  described 
in  this  section.     (Federal  Reserve  Act,  December  23,  1913.) 

b)  To  one  person  or  corporation:  The  total  liabilities  to  any 
association,  of  any  person,  or  of  any  company,  corporation,  or  firm 
for  money  borrowed,  including,  in  the  liabilities  of  a  company  or 
firm,  the  liabilities  of  the  several  members  thereof,  shall  at  no  time 


GOVERNMENT  REGULATION  OF  BANKING  555 

exceed  one-tenth  part  of  the  amount  of  the  capital  stock  of  such 
association  actually  paid  in  and  unimpaired  and  one-tenth  part  of 
the  unimpaired  surplus  fund,  provided  that  the  total  of  such  liabilities 
shall  in  no  event  exceed  thirty  per  centum  of  the  capital  stock  of 
the  association.  But  the  discount  of  bills  of  exchange  drawn  in 
good  faith  against  actually  existing  values,  and  the  discount  of 
commercial  or  business  paper  actually  owned  by  the  person  negotiat- 
ing the  same,  shall  not  be  considered  as  money  borrowed.  (National 
Bank  Act,  as  amended  Jvme  22,  1906.) 

c)  On  security  of  own  stock:  No  association  shall  make  any 
loan  or  discount  on  the  security  of  the  shares  of  its  own  capital  stock, 
nor  be  the  purchaser  or  holder  of  any  such  shares,  unless  such  security 
or  purchase  shall  be  necessary  to  prevent  loss  upon  a  debt  previously 
contracted  in  good  faith ;  and  stock  so  purchased  or  acquired  shall, 
within  six  months  from  the  time  of  its  purchase,  be  sold  or  disposed 
of  at  public  or  private  sale;  or,  in  default  thereof,  a  receiver  may  be 
appointed  to  close  up  the  business.  (National  Bank  Act,  June  3, 
1864.) 

The  restriction  on  real  estate  loans  has  perhaps  given  rise 
to  the  most  criticism  and  controversy.  In  brief,  the  objection 
to  real  estate  loans  is  that  they  are  of  an  unliquid  nature.  They 
are  commonly  made  for  long  periods  of  time;  and  the  mortgages 
given  as  security  are  not  readily  salable  in  a  general  market, 
as  is  the  case  with  stocks  and  bonds.  The  chief  argument  for 
permitting  national  banks  to  make  loans  on  real  estate  mortgage 
security  is  that  it  strengthens  their  competitive  position.  (It 
has  already  been  noted  that  such  restrictions  are  not  found 
in  state  banking  legislation.)'  There  can  be  no  doubt  whatever 
that  the  ability  of  the  state  banking  institutions  to  make  real 
estate  loans  has  given  them  a  decided  advantage  over  national 
banks  in  the  agricultural  sections  of  the  country. 

Without  going  into  an  extended  argument  on  the  merits 
of  the  subject,  it  may  be  suggested  here  that  the  discussion 
in  the  preceding  chapter  with  reference  to  the  Hquidity  of 
bank  assets  in  general  apparently  leads  to  the  conclusion  that 
real  estate  loans  would  hardly  be  less  liquid  in  time  of  crisis 
than  would  any  other  type  of  loan.     As  we  shall  see  in  the  next 

'  See  p.  385.     See  also  p.  561. 


5S6         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

chapter,  the  primary  need  in  time  of  tension  in  the  money 
market  is  access  to  some  unused  reservoirs  of  cash  resources. 
It  appears,  therefore,  that  the  amendment  to  the  National 
Bank  Act  made  by  the  Federal  Reserve  law,  which  permits 
national  banks,  within  limits,  to  make  loans  on  real  estate, 
is  clearly  warranted. 

The  purpose  of  the  limitation  on  the  amount  of  credit  that 
may  be  extended  to  any  one  person  or  corporation  is  to  insure  a 
relatively  wide  distribution  of  risks.  The  exception  to  this 
limitation  stated  in  the  last  sentence  under  (b)  above  is  attribut- 
able to  the  belief  that  two-name  paper  arising  out  of  the 
purchase  and  sale  of  goods  is  always  practically  certain  to  be 
paid.  In  the  light  of  the  discussion  of  the  relative  merits  of 
single  and  two-name  paper  as  given  in  chapter  xix  above, 
however,  it  would  appear  that  there  is  very  little  merit  to  this 
particular  exception. 

The  restriction  against  making  loans  on  the  security  of  a 
bank's  own  stock  is  mainly  the  result  of  some  rather  disas(,rous 
experiences  in  state  banking  practice  before  the  Civil  War. 
We  have  already  seen  that  early  state  banking  laws  permitted 
banks  to  commence  operations  as  soon  as  a  relatively  small 
portion  of  the  capital  stock  had  been  paid  in.  Now  the  shares 
of  stock  already  received  by  shareholders  were  often  used  as 
security  for  loans  from  the  bank.  In  making  the  loan  the 
bank  issued  notes;  and  these  notes  which  passed  current  as 
money  were  then  used  by  the  shareholders  as  a  means  of  pur- 
chasing additional  capital  stock.  Thus  it  came  about  that  a 
large  amount  of  the  bank's  capital  would  be  borrowed  from  the 
bank  itself.  In  other  words,  the  resources  received  by  a  bank 
from  the  sale  of  stock  in  large  measure  consisted  only  of  its 
own  liabilities,  in  the  form  of  its  outstanding  notes.  In  the 
event  of  failure  the  true  situation  was  of  course  quickly  revealed. 

3.  The  regulation  of  reserves.  The  reserve  requirements  of 
the  National  Bank  and  Federal  Reserve  acts  are  given  elsewhere 
in  the  text.'     The  purpose  of  requiring  banks  to  hold  minimum 

'  For  the  reserve  requirements  of  the  National  Bank  Act,  see  pp.  481-82; 
for  the  requirements  under  the  Federal  Reserve  Act,  as  amended,  see 
p.  589. 


GOVERNMENT  REGULATION  OF  BANKING  557 

reserves  of  cash  is  to  prevent  certain  bankers,  who,  because  of 
inadequate  knowledge  of  banking  principles  or  because  of  a 
disposition  to  take  long  chances  with  depositors'  money  in  the 
hope  of  immediate  gain  for  themselves,  might  allow  reserves 
to  be  depleted  to  a  point  which  would  endanger  the  solvency 
of  the  institutions.  It  is  of  interest  to  note  in  this  connection 
that  the  United  States  is  the  only  important  country  that  has 
established  minimum  reserve  requirements.  Whatever  may  be 
the  case  in  other  countries,  however,  our  own  banking  experience 
has  pretty  definitely  shown  the  wisdom  of  such  requirements. 
In  the  early  days  of  banking  many  institutions  kept  practically 
no  reserves  whatever,  with  the  result  that  their  outstanding 
notes  depreciated  in  value  and  wrought  havoc  with  the  monetary 
system. 

One  weakness  should  be  noted,  however,  in  the  requirement 
of  minimum  reserves.  If  there  is  fixed  an  absolute  minimum 
under  which  banks  may  not  cut  even  in  case  of  an  emergency, 
a  rigidity  is  given  to  the  banking  system  in  time  of  credit  strain 
that  is  highly  unfortunate.  It  may  well  be  argued  that  it  is 
better  to  have  no  minimum  requirements  at  all  and  to  rely 
upon  the  banks  to  maintain,  on  grounds  of  self-interest,  some 
reserves  which  will  be  available  for  use  in  time  of  emergency 
than  to  require  very  high  reserves  which  may  not  be  used 
in  case  of  need.  It  is  significant  in  this  connection  that  the 
Federal  Reserve  Act  permits  the  minimum  reserves  that  are  re- 
quired for  Federal  Reserve  banks  to  be  cut  under  in  case  of 
great  emergency.' 

In  times  of  financial  strain  the  publication  of  the  fact-  that 
reserves  are  down  to  the  minimum  permitted  by  law  also, 
unfortunately,  excites  the  general  public  and  sometimes  leads 
to  a  hoarding  of  currency,  which  seriously  embarrasses  the 
banks  at  a  moment  when,  so  far  as  fundamental  conditions  are 
concerned,  no  real  danger  of  panic  is  imminent. 

4.  Banking  examinations  and  reports.  As  a  means  of 
enforcing  the  provisions  of  the  National  Bank  Act,  there  has 
been  established  in  the  Treasury  Department  a  separate  bureau 

'  See  p.  597. 


558  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

under  the  direction  of  the  Comptroller  of  the  Currency.  The 
Comptroller  appoints  examiners  whose  duty  it  is  to  examine 
each  bank  in  the  federal  syfetem  at  least  twice  each  calendar 
year,  and  oftener  than  that  if  considered  necessary.  In  case 
these  examinations  reveal  malpractices,  inefficient  banking 
methods,  or  a  failure  to  conform  fully  with  the  requirements 
of  the  law,  action  is  taken  to  correct  the  weaknesses  disclosed; 
and  if  they  are  not  shortly  corrected,  the  charter  is  forfeited. 

The  national  bank  examiners  also  render  assistance  to  the 
Comptroller  of  the  Currency  in  helping  him  to  form  a  judgment 
upon  the  advisability  of  granting  an  application  for  a  national 
bank  charter.  It  is  the  duty  of  the  Comptroller  not  only  to 
make  certain  that  a  new  bank  will  conform  with  all  the  require- 
ments of  the  incorporation  law,  but  also  to  make  sure  that 
there  is  a  reasonable  need  for  the  organization  of  an  additional 
bank  in  the  community  in  question;  for  one  of  the  most  potent 
causes  of  bank  failures  is  the  multiplication  of  banking  facilities 
beyond  the  needs  of  business.  The  examiners  are  effectively 
utilized  in  gathering  information,  on  the  basis  of  which  the 
Comptroller  can  make  an  intelligent  decision  as  to  the  possibility 
of  success  for  a  new  bank. 

Every  national  bank  is  also  required  to  make  five  reports 
each  year  to  the  Comptroller  of  the  Currency,  exhibiting  in 
detail  the  resoiirces  and  liabilities  of  the  institution  at  the  close 
of  business  on  any  past  date  specified  by  the  Comptroller.  The 
Comptroller  may  also  call  for  special  reports  from  any  particular 
bank  whenever  it  is  deemed  necessary.  From  the  data  thus 
obtained  the  Comptroller  is  enabled  to  judge  the  conditions  of 
banking  and  general  business  from  time  to  time,  as  well  as  the 
status  of  each  particular  bank.  He  is  also  in  a  position  to  submit 
an  annual  report  to  Congress,  presenting  a  summary  of  banking 
conditions  and  recommending  any  legislation  which  such 
conditions  seem  to  warrant.  These  reports,  moreover,  con- 
stitute a  veritable  mine  of  information  which  is  available  for 
the  use  of  students  of  banking  theory  and  practice.  Since  the 
establishment  of  the  Federal  Reserve  System,  however,  the 
importance  of  the  work  of  the  Comptroller  of  the  Currency  has 


GOVERNMENT  REGULATION  OF  BANKING  559 

very  greatly  declined,  being  overshadowed  by  that  of  the 
Federal  Reserve  Board.  There  is,  in  fact,  no  longer  any  good 
reason  for  the  continuance  of  the  Comptroller's  oflSce;  the 
functions  performed  should  be  taken  over  by  the  Federal  Reserve 
Board. 

m.    THE  REGULATION  OF  STATE  BANKING 

In  the  foregoing  discussion  of  banking  regulation  the  ref- 
erences have  all  been  to  the  provisions  of  the  national  banking 
laws.  It  remains  to  compare  the  banking  regulations  of  the 
various  states  with  those  of  the  federal  government.  State 
banks  are  under  the  general  supervision  of  state  officials, 
designated  by  various  names,  the  most  common  of  which  is 
perhaps  State  Superintendent  of  Banking.  They  are  subjected 
to  official  examinations  and  are  required  to  submit  periodical 
reports,  as  is  the  case  with  national  banks.  In  recent  years 
there  has  been  worked  out  a  rather  effective  co-operation 
between  national  and  state  bank  examiners.  Summaries  of 
the  reports  of  state  banking  conditions  are  also  included  in  the 
annual  volume  published  by  the  national  Comptroller  of  the 
Currency. 

State  bank  legislation  is  similar  to,  though  usually  less  strin- 
gent than,  national  bank  regulation.  The  following  summary 
statement  will  indicate  the  character  of  state  as  compared  with 
national  bank  legislation.^ 

The  minimum  capital  required  for  state  banks  varies  in  the 
different  states  from  nothing  to  $50,000.  In  the  South  and  West 
the  requirement  is  less  than  the  $25,000  required  for  national  banks. 
Some  twenty  states  require  but  $10,000  or  less.  In  twenty-nine 
of  the  thirty-seven  states  and  territories  which  require  a  minimum 
under  a  general  law,  the  amount  is  graded  according  to  population. 
In  most  of  these  states  $25,000  is  the  maximum,  though  several 
require  $100,000.  As  compared  with  the  national-bank  minimum 
of  $25,000  for  towns  of  less  than  three  thousand  population,  three 

'Adapted  from  J.  F.  Ebersole,  "The  Relation  of  State  to  National 
Banks,"  Proceedings  of  the  American  Academy  of  Political  and  Social 
Science,  I  (1911),  286-90. 


S6o  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

states  have  higher,  seven  states  have  the  same,  and  seventeen  have 
lower  requirements.  As  compared  with  the  national-bank  require- 
ment of  $50,000  for  places  of  three  thousand  to  twenty-five  thousand 
population,  over  three-fourths  of  the  states  which  prescribe  a  fixed 
capital  have  lower  requirements.  None  of  the  state  laws  rec[uire 
more  than  does  the  national  law,  while  several  require  much  less. 
For  cities  of  twenty-five  thousand  to  one  hundred  and  fifty  thousand, 
three-fourths  of  all  the  states  have  lower  requirements  than  the 
national-bank  requirement  of  $100,000. 

This  difference  in  the  amount  of  capital  required  is  one  of  the 
noteworthy  contrasts  between  national  and  state  legislation,  and 
this  difference  exists  not  in  legislation  only.  Sixty-two  per  cent  of 
the  11,319  state  banks  in  operation  on  April  28,  1909,  had  less  than 
$25,000,  and  27  per  cent  had  capital  ranging  between  $10,000  and 
$15,000.  A  few  states  show  some  lack  of  banking  ideals  in  per- 
mitting an  authorized  capital  larger  than  the  paid-in  requirements, 
undue  prolongation  of  the  paying  in  of  capital,  and  the  payment  of 
subscriptions  to  capital  by  means  other  than  "cash"  or  "money  of 
the  United  States. " 

The  National  Bank  Act  requires  one-tenth  of  the  net  earnings 
to  be  set  aside  annually  toward  a  surplus  fund  until  it  amoimts  to 
one-fifth  of  the  capital.  Nineteen  states  have  this  rule;  seven  states 
have  more  stringent  provisions;  Virginia  has  a  lower  requirement, 
and  seventeen  states  do  not  require,  by  general  law,  such  a  surplus 
accumulation.  In  addition  to  this  surplus  fund  added  to  capital, 
most  states  follow  the  National  Bank  Act  in  providing  for  the  double 
liability  of  shareholders.  In  nineteen  states  the  shareholders  are 
responsible  "equally  and  ratably  and  not  for  another. "  In  fourteen 
states  the  shareholders  are  liable  "jointly  and  for  each  other." 
Sixteen  other  states  are  more  lenient,  imposing  no  statutory  liabihty 
whatever.  , 

With  reference  to  the  regulation  of  loans  the  state  banking  laws 
are  in  general  more  liberal  than  the  federal  law.  The  National 
Bank  Act  limits  the  amount  of  any  single  habiUty  due  a  national 
bank  to  one-tenth  of  its  capital  and  surplus  and  to  30  per  cent  of 
its  capital  stock.  With  the  exception  of  two  states  the  state  banking 
laws  arc  far  more  hberal.  Some  twenty-two  states  allow  from 
1 5  per  cent  to  30  per  cent  of  capital  and  surplus  as  the  limit  to  each 
individual  liability  to  a  bank,  and  ten  states  have  no  limitations 
whatever. 


GOVERNMENT  REGULATION  OF  BANKING  561 

The  National  Bank  Act  permits  an  excess  if  it  consists  of  advances 
of  bona  fide  bills  of  exchange  and  commercial  paper  actually  owned 
by  the  negotiator.  The  state  laws,  in  addition  to  these,  make 
exceptions  in  favor  of  loans  on  real  estate  mortgages  (six  states); 
loans  on  bills  of  lading  and  warehouse  receipts  (eight  states);  loans 
on  collateral  security  (fifteen  states) ;  and  loans  approved  by  a  vote  of 
the  directors  (four  states).  This  greater  liberality  may  be  accounted 
for  by  the  smaller  size  of  most  of  the  state  banks  and  the  difficulty 
of  enforcing  restrictions.  Even  in  the  national  system  enforcement 
is  not  easily  accomplished,  for  as  late  as  September,  1909,  over  one 
thousand  banks  (or  15  per  cent  of  the  total)  voluntarily  reported 
excessive  loans.  Several  of  the  eastern  states  have  recently  set 
limitations  as  to  the  amount  of  any  one  loan,  irrespective  of  the 
individual's  liability. 

Another  unportant  contrast  between  national  and  state  banks  is 
the  power  conferred  upon  the  latter  and  denied  the  former  to  loan 
upon  real  estate.  A  few  states  limit  the  amount  to  be  put  into  real 
estate  loans.  The  prevailing  practice  is  to  limit  these  loans  to  50 
per  cent  of  the  capital  or  capital  and  surplus.  A  few  place  the  limit 
at  from  15  per  cent  to  40  per  cent  of  the  assets,  and  some  at  20  per 
cent  of  the  loans.  State  laws  define  the  character  of  these  loans 
as  to  the  location  of  the  property,  the  character  of  the  lien,  or  the 
proportion  which  the  value  of  the  real  estate  must  bear  to  the  amount 
of  the  loan.  Holdings  of  real  estate  are  limited  to  a  five-year  duration 
following  a  foreclosure  sale. 

These  real  estate  loans  are  a  larger  proportion  of  the  total  loan? 
in  the  smaller  towns  and  cities.  And  "notwithstanding  the  dis- 
advantages of  real  estate  as  a  convertible  asset,  the  power  to  loan  op 
the  security  of  real  estate  is  a  valuable  one  to  many  of  the  state 
banks."  On  April  28,  1909,  20.6  per  cent  of  the  total  loans  and 
discounts  of  state  banks  were  based  upon  security  of  this  character. 
Insofar  as  the  deposits  of  state  banks  are  time  deposits,  this  form  ol 
lending  cannot  be  troublesome,  though  it  is  not  suitable  for  active 
commercial  banks  in  large  centers  of  population. 

The  third  great  difference  between  national  and  state  bank  laws 
is  found  in  the  reserve  requirements.  Here,  also,  the  state  and 
territorial  laws  are  the  more  lenient.  At  present  (1910)  in  ten  states 
no  reserve  whatever  is  required  for  incorporated  banks.  In  fourteen 
states  a  reserve  is  required  only  against  demand  deposits.  The 
amount  ranges  from  10  per  cent  to  25  per  cent,  although  15  per  cent 


562  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

is  commonly  required.  In  six  other  states  a  lower  reserve  is  required 
against  time  deposits  than  against  demand  deposits.  This  ranges 
from  4  per  cent  to  15  per  cent  for  time  deposits  as  against  15  per 
cent  to  25  per  cent  for  demand  deposits.  In  sharp  contrast  the 
National  Bank  Act  requires  from  15  per  cent  to  25  per  cent  of  all 
deposits.    This  example  has  been  followed  in  but  thirteen  states. 

Not  only  in  regard  to  the  amount  of  reserve,  but  also  as  to  its 
form,  do  state  and  national  laws  differ.  All  states  permit  balances 
in  other  banks  to  be  counted  as  a  part  of  the  reserve.  The  amount 
of  redeposit  so  authorized  varies  from  one-half  to  three-fourths. 

In  seven  states  "the  banks  determine  for  themselves  what  part 
of  their  reserves  shall  be  cash  in  bank  and  what  part  shall  be  in  the 
form  of  bank  balances."  In  four  states  bonds  may  be  coimted  in 
the  reserve.  In  the  choice  of  depositaries  the  state  banks  are  practi- 
cally unrestricted.  In  but  five  states  are  distinctions  made  between 
the  reserves  required  of  ordinary  banks  and  reserve  agents. 

The  trust  company  legislation  of  the  various  states  has  been 
even  more  lenient  than  thai  pertaining  to  state  commercial  hanks. 
This  statement  applies  to  the  granting  of  loans,  to  the  main- 
tenance of  specie  reserves,  and  to  full  subscriptions  to  capital 
stock,  though  not,  typically  speaking,  to  the  minimum  capital 
requirement.  Trust  company  legislation  is  in  recent  years, 
however,  being  brought  into  closer  conformity  with  state 
banking  legislation, 

IV.  THE  REGULATION  OF  BANK  NOTES 

The  regulation  of  bank-note  issues  is  presented  here  as  a 
distinct  and  separate  phase  of  the  problem  of  banking  organi- 
zation and  control  only  because  of  its  historical  importance, 
bank-note  regulation  having  given  rise  to  more  discussion  and 
controversy  than  have  all  the  other  problems  of  banking  control 
combined.  The  discussion  that  from  the  very  beginning  of  our 
banking  history  has  centered  around  the  issue  of  notes  is 
attributable  in  part  to  the  fact  that  notes  were  long  the  primary 
form  in  which  bank  obligations  were  manifested;  in  part  to 
the  fact  that  they  pass  from  hand  to  hand  as  currency  without 
regard  to  the  character  of  the  persons  passing  them  on,  and 
form,  in  consequence,  a  part  of  the  money  supply  of  the  country 


GOVERNMENT  REGULATION  OF  BANKING  563 

and  in  part  to  the  fact  that  we  look  to  bank  notes  to  provide 
the  necessary  flexibility  in  the  currency  system  as  a  whole. 

There  are  three  principal  ends  to  be  achieved  when  regulat- 
ing bank-note  issues:  (i)  they  must  at  all  times  be  maintained 
at  a  parity  with  standard  money;  (2)  they  must  be  amply 
secured  so  that  there  can  be  no  question  of  their  ultimate  value; 
and  (3)  they  must  be  made  elastic,  that  is,  responsive  to  the 
varying  requirements  of  trade.  During  our  earlier  history  the 
first  two  of  these  problems  were  the  chief  sources  of  controversy; 
but  in  recent  years — with  immediate  parity  and  ultimate 
secm-ity  accomplished  facts — ^the  discussion  has  centered 
around  the  problem  of  elasticity. 

1.  Maintaining  the  parity  of  bank  notes.  Since  bank  notes 
are  designed  to  pass  from  hand  to  hand  as  currency  it  is  necessary 
to  insmre  at  all  times  their  parity  with  standard  money,  lest 
their  issue  lead  to  a  depreciation  of  the  currency  and  a  general 
unsettling  of  prices.  Various  devices  have  been  employed 
for  insuring  the  parity  of  bank  notes,  the  chief  of  which  are 
(i)  making  them  a  legal  tender  in  some  very  important  con- 
nection, such  as  in  the  payment  of  taxes,  and  (2)  providing  for 
their  easy,  quick,  and  constant  convertibility  into  standard 
money.^  The  first  of  these  devices  has  never  by  itself  been 
found  adequate,  although  it  no  doubt  may  have  contributed 
somewhat  to  the  success  of  the  other  methods. 

In  order  to  insure  the  continuous  convertibility  of  bank 
notes  into  standard  money  it  is  necessary,  first,  that  the  issuing 
bank  stand  ready  at  all  times  to  redeem  its  own  notes  when 
presented  over  its  counter.  But  in  order  to  keep  the  notes  at 
par  when  they  have  wandered  far  from  the  issuing  bank  it  has 
also  been  found  necessary  to  make  them  redeemable  at  certain 
agencies  in  important  banking  centers  with  which  banks  every- 
where are  in  close  relations;  or  to  make  them  redeemable  at  the 
Treasury  of  the  United  States.  This  latter  method  is  employed 
in  connection  with  our  present  national  bank  notes. 

2.  The  security  of  bank  notes.  This  aspect  of  the  problem 
of  bank-note  regulation  relates  to  the  ultimate  value  of  bank 

*  For  other  methods  see  pp.  98-100. 


564  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

notes  rather  than  to  their  immediate  convertibiHty  into  specie. 
Several  different  methods  have  been  employed  to  insure  the 
holders  of  bank  notes  against  ultimate  loss,  the  three  most 
common  of  which  are  as  follows:  (i)  To  rely  upon  the  adequacy 
of  the  bank's  assets  to  meet  all  note  obligations  in  full.  This  is 
sometimes  accompanied  by  a  provision  which  gives  the  holders 
of  notes  a  prior  claim  against  the  assets  of  the  bank.  (2)  To 
require  the  bank  to  maintain  a  special  security  for  a  note  issue, 
such  as  government  bonds.  This  is  the  method  employed  by 
the  national  banking  system  of  the  United  States.  (3)  To 
require  the  bank  to  set  aside  certain  of  its  commercial  assets  as 
security  for  its  note  issues.  This  third  method  is  specifically 
designed  to  promote  elasticity  in  the  bank-note  system  rather 
than  to  insure  safety.  It  is  believed,  however,  that  both 
safety  and  elasticity  can  thus  be  attained. 

It  is  unnecessary  at  this  place  to  present  the  history  of 
bank-note  regulation,  or  to  enter  into  a  discussion  of  the 
various  problems  of  regulation  associated  with  the  issue  of  bank 
notes,  for  they  receive  sufficient  attention  elsewhere  in  the  text. 
The  weaknesses  of  the  system  of  bond-secured  notes  from  the 
viewpoint  of  elasticity  are  discussed  in  the  preceding  chapter, 
while  the  advantages  of  asset  currency  in  the  same  connection 
will  be  pointed  out  in  the  analysis  of  Federal  Reserve  notes  in 
the  chapter  which  follows. 

QUESTIONS  FOR  DISCUSSION 

1.  Can  you  advance  any  sound  arguments  against  the  abolition  of 
private  banking  ? 

2.  Draw  up  a  statement  of  the  arguments  against  private  banking. 

3.  What  is  meant  by  free  banking?  What  are  the  arguments  in 
favor  of  it  ? 

4.  What  are  the  weaknesses  in  the  system  of  general  incorporation  ? 

5.  How  would  you  determine  how  large  a  capital  a  particular  bank, 
to  be  located  in  a  particular  community,  should  have  ? 

6.  Do  you  have  any  criticisms  to  offer  of  the  capital  requirement* 
under  the  National  Bank  Act  ?  under  the  state  banking  laws,  ai 
summarized  on  pages  559-60  ? 


GOVERNMENT  REGULATION  OF  BANKING  565 

7.  In  what  way  does  the  accumulation  of  a  surplus  tend  to  increase 
the  security  of  a  bank's  creditors  ? 

8.  Would  you  favor  the  abolition  of  the  double  liability  requirement 
for  bank  shareholders  ?  Would  you  favor  the  extension  of  this 
principle  to  non-banking  corporations  ? 

^.  What  is  the  objection  to  allowing  a  bank  to  commence  business 
before  the  capital  is  fxilly  paid  in  ? 

10.  Write  out  a  summary  statement,  giving  the  arguments  for  the 
various  provisions  governing  the  making  of  bank  loans. 

11.  What  do  you  think  of  the  argument  that  it  is  dangerous  for  a 
commercial  bank  to  make  any  considerable  volume  of  loans  on  the 
seauity  of  real  estate  mortgages  ? 

12.  If  you  were  asked  to  draw  up  a  banking  system  for  one  of  the 
Central  American  states,  would  you  follow  the  American  practice 
of  requiring  minimum  specie  reserves,  or  the  European  practice 
of  permitting  each  bank  to  formulate  its  own  reserve  policy  ? 

13.  Look  through  one  of  the  annual  reports  of  the  Comptroller  of  the 
Currency  in  the  library  and  draw  up  an  outline  statement  of  the 
significant  data  that  it  contains. 

14.  Which  of  the  various  ends  to  be  achieved  in  the  regulation  of 
bank  notes  do  you  regard  as  most  important  ?  which  the  most 
difiicult  of  attaining  ? 

REFERENCES  FOR  FURTHER  READING 

Agger,  Eugene  E.:  Organized  Banking,  chap.  xii. 

Dunbar,  Charles  F.:  Chapters  in  the  History  and  Theory  of 
Banking,  3d  edition,  enlarged  by  O.  M.  W.  Sprague,  chap.  xi. 

Moulton,  Harold  G.:  Principles  of  Money  and  Banking,  Part  II, 
chap.  vi. 

Scott,  William  A.:  Money  and  Banking,  chaps,  ix  and  x. 

Willis,  H.  Parker:  Atnerican  Banking,  chaps,  xiii  and  xiv. 


CHAPTER  XXV 

THE  FEDERAL  RESERVE  SYSTEM 

The  adoption  of  the  Federal  Reserve  Act  on  December  23, 
1913,  marks  the  beginning  of  a  new  era  in  American  banking 
development.  For  the  first  seventy  years  of  our  national 
history  banking  as  a  business  was  conducted  almost  entirely 
under  the  regulation  of  the  various  states,  with  a  resulting 
heterogeneity  of  banking  laws  and  banking  practice.  The 
national  banking  system,  dating  from  the  Civil  War,  gave  us, 
as  we  have  seen,  a  uniform  and  a  safe  bank-note  currency — 
though  not  a  flexible  one — and  in  general  marked  a  real  advance 
in  the  development  of  banking  organization.  With  the  passage 
of  the  Federal  Reserve  Act,  fifty  years  later,  we  have  entered 
upon  a  third  stage  in  our  banking  evolution,  a  stage  that  may  be 
characterized  as  one  in  which  a  long  step  has  been  taken  toward 
centralization  in  the  control  of  banking,  one  in  which  the 
differences  between  state  and  national  banking  are  being  slowly 
but  surely  eliminated,  and  one  under  which  the  vast  economic 
power  that  inevitably  resides  in  the  financial  system  can  be 
made  to  subserve  as  never  before  the  larger  interests  of  commerce 
and  industry. 

I.    THE  HISTORY  OF  BANKING  REFORM 

The  shortcomings  of  the  national  banking  system,  as  it 
existed  before  1914,  were  revealed  to  close  students  of  the 
question  in  almost  every  period  of  seasonal  or  cyclical  strain 
upon  the  money  markets.  But  reform  of  our  banking  laws 
was  slow  in  developing,  in  part  because  other  financial  issues 
took  precedence  and  in  part  because  the  defects  which  had 
been  disclosed  appeared  in  the  main  to  be  such  as  required 
amendment  merely,  rather  than  thoroughgoing  reorganization. 
The  generation  following  the  Civil  War  was  one  in  which  dis- 

S66 


THE  FEDERAL  RESERVE  SYSTEM  567 

cussion  of  banking  regulation  was  largely  overshadowed  by 
the  agitation  for  greenback  currency  and  the  restoration  of 
the  free  coinage  of  silver,  the  principal  objection  to  the  national 
banking  system  being  the  so-called  "double-profit"  on  note 
issues — ^interest  on  government  bonds,  plus  interest  on  the 
notes.  These  controversies  related  rather  to  the  total  quantity 
of  money  and  to  the  sources  of  the  national  currency  supply 
than  to  the  adaptability  of  the  banking  machinery  to  the  varying 
requirements  of  trade. 

The  panic  of  i8q3  precipitated  a  genuine  agitation  for  the 
improvement  of  our  banking  system.  The  most  noteworthy 
proposal  was  the  "Baltimore  Plan"  of  1894,  modeled  after  the 
Canadian  system  of  protecting  note  issues  by  a  joint  guaranty 
fund  contributed  to  by  all  banks.  Before  any  legislation  on  the 
subject  could  be  passed,  however,  there  occurred  the  political 
campaign  of  1896,  the  issue  of  which  was  once  more  the  silver 
question.  The  success  of  the  Republicans  in  this  campaign 
was  followed  by  the  appointment  of  a  monetary  commission, 
composed  of  representatives  of  boards  of  trade,  chambers  of 
commerce,  and  other  similar  bodies,  which  met  in  Indianapolis 
in  1897  for  the  purpose  of  "making  a  thorough  investigation 
of  the  monetary  affairs  and  needs  of  the  country  in  all  relations 
and  aspects,  and  submitting  proper  suggestions  as  to  the 
evils  found  to  exist  and  the  remedies  therefor."  The  findings 
of  the  commission  were  given  publication  and  a  bill  embodying 
the  conclusions  reached  was  presented  in  Congress  in  1898. 

The  Currency  Act  of  March  14,  1900,  carried  some  of 
these  recommendations  into  effect.  In  the  main,  however, 
this  act  was  concerned  with  the  money  rather  than  with  the 
banking  question.  On  the  banking  side  all  that  was  attempted 
was  a  stimulation  of  the  growth  of  national,  as  compared  with 
state,  banks  by  decreasing  the  capital  requirements  and  by 
permitting  the  issue  of  notes  up  to  the  full  value  of  the  govern- 
ment bonds  held  as  security.  It  appears  that  with  the  return 
of  great  business  prosperity  the  need  of  reforming  our  banking 
system  did  not  seem  serious  to  our  legislators,  who  at  best 
perceived  none  too  clearly  the  fundamental  weaknesses  inherent 


$68  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

in  the  system.  The  return  of  the  Republicans  to  power, 
coupled  with  the  establishment  of  a  gold  standard,  undoubtedly 
satisfied  most  congressmen  that  henceforth  financial  difl&culties 
would  be  unknown.  Agitation  for  banking  reform  continued, 
however,  among  scientific  students  of  the  question,  and  there  were 
also  some  congressmen,  notable  among  whom  was  Charles  N. 
Fowler,  chairman  of  the  Banking  and  Currency  Committee  of 
the  House,  who  persistently  endeavored  to  seciue  the  passage 
of  remedial  legislation,  designed  primarily  to  insure  an  elastic 
bank-note  currency  based  on  commercial  assets. 

The  disastrous  financial  panic  of  igoj  raised  anew  the  agitaiion 
for  hanking  reform,  both  in  and  out  of  Congress.  It  was  observed 
that  whereas  other  countries  were  equally  subject  to  periodic 
fluctuations  of  commerce  and  trade,  the  United  States  appeared 
to  be  the  only  nation  in  which  the  banking  machinery  was 
incapable  of  alleviating  the  conditions  that  developed  in  time 
of  crisis.  Strong  pressure,  partly  political,  was  brought  on 
Congress  to  pass  some  emergency  legislation;  and  after  a  very 
brief  study  of  the  problem  there  was  passed  the  Aldrich- 
Vreeland  Act  of  1908,  which  made  possible  the  issue,  under  the 
control  of  currency  associations  organized  around  the  clearing- 
house associations  as  nuclei,  of  bank  notes  secured  by  state  and 
municipal  bonds  or  by  commercial  paper.  This  act  was  frankly 
passed  as  an  interim  measure,  to  expire  at  the  end  of  five  years; 
and  during  this  interval  it  was  hoped  a  genuine  reorganization  of 
the  banking  system  might  be  effected. 

The  Aldrich-Vreeland  emergency  currency  performed  an 
important  service  ai  the  outbreak  of  the  Great  War.  It  turned  out 
that  the  Federal  Reserve  System,  though  authorized,  was  not  in 
operation  at  the  end  of  five  years  and  the  Aldrich-Vreeland  Act 
was  accordingly  extended  for  a  sixth  year.  At  the  eleventh  hour 
this  law  received  a  real  test;  for  only  a  few  months  before  the 
Federal  Reserve  System  was  ready  for  operation  the  outbreak 
of  the  war  in  Europe  precipitated  a  sharp  financial  crisis  in  the 
United  States.  Three  hundred  and  sixty-eight  million  dollars 
of  emergency  currency  notes,  nearly  three-fifths  of  which  were 
secured  by  commercial  paper,  were  issued.    The  effect  was 


THE  FEDERAL  RESERVE  SYSTEM  569 

most  salutary  and  the  expedient  carried  us  through  a  genuine 
currency  stringency  which  might  otherwise  have  resulted 
seriously.  It  should  be  chronicled,  however,  that  this  crisis 
differed  materially  from  such  a  one  as  follows  a  period  of  great 
industrial  activity  which  involves  a  very  great  expansion  of 
credit.  The  general  business  situation  in  1914  had  been  one 
of  relative  depression. 

The  most  significant  provision  of  the  Aldrich-Vreeland  Act, 
however,  was  that  which  established  a  National  Monetary  Com- 
mission, composed  of  eighteen  congressmen,  which  was 
instructed  to  make  a  thoroughgoing  investigation  of  banking 
and  cmrency  reform  and  to  frame  a  bill  for  the  creation  of 
a  new  and  panic-proof  banking  system.  Under  the  chairman- 
ship of  Senator  Aldrich,  this  commission  conducted  a  very 
extensive  investigation,  drawing  upon  the  experience  of  the 
entire  world.  Public  hearings  were  held  in  the  leading  financial 
centers  of  Europe;  mmierous  experts  were  drafted  to  make 
special  investigations  on  various  aspects  of  the  problem,  both 
in  the  United  States  and  abroad;  and  a  number  of  books  and 
monographs  on  special  banking  problems  were  reprinted  and 
published  as  part  of  the  commission's  findings.^ 

Meanwhile  other  students  of  the  question  were  also  at 
work  on  plans  for  the  reorganization  of  our  banking  system. 
Niunerous  proposals  were  advanced  by  independent  students — 
bankers  and  economists — and  many  measures  were  introduced 
into  Congress,  the  most  important  of  which  was  one  by  Mr. 
Fowler  entitled  "A  bill  to  estabUsh  a  complete  financial  and 
banking  system. " 

The  Aldrich  hill,  resulting  from  the  investigations  of  the 
monetary  commission,  was  presented  to  Congress  in  January, 
191 1.  In  brief,  this  bill  provided  for  a  new  banking  organi- 
zation modeled  rather  closely  after  the  central  banking  systems 
of  Europe;  but  because  of  American  opposition  to  centralization 
of  power,  particularly  financial  power,  and  because  of  the 
unfortunate  experience  in  our  early  history  in  connection  with 
the  Second  Bank  of  the  United  States,'  it  was  felt  that  a  bill 
proposing  the  estabUshment  of  a  central  bank  would  have  no 

*  About  forty-five  voliimes  of  material  were  published. 

» See  pp.  S49-S0. 


S70  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

chance  of  becoming  a  law.  Accordingly,  resort  was  had  to 
camouflage  and  it  was  proposed  to  establish  a  national  reserve 
association,  with  headquarters  in  Washington  and  with  branches 
in  various  leading  financial  centers  throughout  the  land.  The 
Aldrich  bill  met  with  very  vigorous  opposition,  however,  and 
there  was  at  no  time  much  chance  of  its  enactment  into  law. 
While  embodying  many  excellent  features,  it  also  possessed 
certain  important  defects;  moreover,  it  looked  suspiciously 
like  "un-American  centralization  of  power,"  and  above  all  it 
was  sponsored  by  Senator  Aldrich,  who  at  the  time  was  in 
particularly  bad  grace  with  the  American  people  because  of 
the  part  he  had  played  in  foisting  upon  the  country  the  objec- 
tionable tariff  law  of  1909. 

Currency  reform  shortly  became  the  all-absorbing  national 
issue  of  the  time.  While  the  Aldrich  bill  was  before  Congress, 
there  was  established  a  "National  Citizen's  League  for  the 
Promotion  of  a  Sound  Banking  System."  This  league,  which 
was  financed  mainly  by  the  banking  interests  of  New  York 
and  Chicago — in  good  faith  and  in  the  hope  that  a  really  efficient 
banking  system  might  be  established — undertook  to  educate 
the  American  people  on  the  subject  of  currency  reform.  There 
was  published  a  weekly  magazine  called  Banking  Reform, 
and  also  a  small  volume  with  the  same  title,  which  were  devoted 
to  a  discussion  of  the  defects  of  the  national  banking  system 
and  to  outlining  in  general  terms  the  principles  which  any 
legislation  that  would  correct  these  evils  must  embody.  Organi- 
zations were  formed  in  a  great  many  states  and  speakers  for 
the  league  addressed  commercial  clubs,  bankers'  associations, 
trade  conferences,  agricultural  associations,  public  schools, 
etc.,  throughout  the  land.  While  the  league  was  willing  to 
see  the  Aldrich  bill  adopted,  believing  that  most  of  the  essential 
principles  were  incorporated,  it  wisely  took  the  stand  that  it 
was  not  sponsoring  any  particular  bill,  that  its  interest  was  onl}- 
in  securing  the  adoption  of  a  sound  banking  system.  The  evils 
to  be  overcome  were,  however,  repeatedly  pointed  out  and 
there  was  constant  reiteration  of  the  general  principles  which 
any  constructive  banking  legislation  must  incorporate. 


THE  FEDERAL  RESERVE  SYSTEM  571 

Meanwhile  the  Democratic  party  was  returned  to  power 
as  a  result  of  the  political  exigencies  of  191 2.  Since  the  party 
was  traditionally  weak  in  its  treatment  of  financial  questions, 
and  the  new  Congress  was  largely  inexperienced,  it  was  felt  by 
many  that  little  was  now  to  be  hoped  for  in  the  way  of  con- 
structive banking  legislation.  There  were  a  few  distinctly 
good  men  in  Congress,  however,  and  the  President  very  wisely 
seized  the  opportunity  presented  by  a  united  party  and  some 
efficient  leadership,  to  put  through  a  whole  series  of  important 
legislative  measures.  The  nation-wide  sentiment  that  had 
been  developed  in  favor  of  a  sound  banking  system  made  it 
imperative  that  this  problem  be  given  primary  attention. 
In  fact,  some  progress  had  already  been  made  before  the  new 
administration  was  seated.  A  preliminary  draft  of  what  later 
became  the  Federal  Reserve  Act  was  worked  out  between 
April,  1912,  and  June,  1913,  under  the  auspices  of  the  sub- 
committee of  the  House  Banking  and  Currency  Committee,  of 
which  Carter  Glass  was  chairman,  and,  after  the  close  of  the 
Sixty-Second  Congress,  under  the  personal  direction  of  Mr. 
Glass  as  the  prospective  chairman  of  the  Banking  and  Currency 
Committee  of  the  incoming  Democratic  Congress. 

The  task  of  framing  a  currency  law  was  conceived  as  one  of 
modifying  the  Aldrich  bill  in  such  a  way  as  to  meet  the  funda- 
mental objections  that  had  been  raised  to  that  measure  and  to 
perfect  a  banking  organization  that  would  provide  the  necessary 
centralization  of  power  without  vesting  too  much  control  in  the 
hands  of  the  ''financial  interests";  it  was  felt  that  a  democratic 
spirit  should  pervade  the  organization  and  that  it  should  be 
developed  in  accordance  with  the  "genius  of  our  institutions" — 
whatever  may  be  meant  by  this  well-sounding  phrase.  The 
Democratic  party  thus  reaped  the  fruits  of  the  investigations 
that  had  been  conducted  by  the  National  Monetary  Commission 
and  by  other  students  of  banking  reform,  as  well  as  the  advan- 
tage of  the  criticisms  that  had  been  made  of  the  Aldrich  bill; 
and  especially  it  profited  by  the  nation-wide  discussion  of  the 
fundamental  principles  involved  in  banking  reform.  Great 
credit  must,  however,  be  given  to  the  Democratic  leaders  for 


572         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  eflScient  way  in  which  the  problem  was  handled  and  for  the 
speed  with  which  the  bill  was  enacted  into  law. 

The  Federal  Reserve  Act  is  a  substantial  improvement  over 
the  Aldrich  plan.  It  should  be  chronicled  here  that  the  Federal 
Reserve  Act  is  not  a  mere  plagiarism  of  the  Aldrich  plan.  In 
certain  fimdamental  respects  the  new  law  is  markedly  different 
from  and  markedly  superior  to  the  Aldrich  plan.  A  writer  very 
intimately  associated  with  the  entire  banking  reform  movement 
states  these  differences  in  the  following  language: 

The  Aldrich  bill  provided  for  a  single  central  "reserve  asso- 
ciation" with  scanty  public  oversight,  with  control  vested  practically 
wholly  in  the  banks,  and  with  the  preponderance  of  power  in  the 
hands  of  the  larger  institutions  which  owned  stock.  It  so  arranged 
things  as  to  keep  this  "reserve  association"  relatively  inactive  except 
upon  special  occasions  of  panic  or  disturbance.  It  made  no  direct 
provision  for  the  shifting  of  reserves  in  part  from  existing  banks  to 

the  proposed  associations The  new  Act  provides  for  twelve 

reserve  banks,  introduces  the  principle  of  local  control,  calls  for 
strict  government  oversight,  shifts  reserves  from  present  corre- 
spondent banks  to  new  institutions,  minimizes  the  influence  of  the 
larger  banks  in  directorates,  and  generally  diffuses  control  instead  of 
centrahzing  it.  It  leaves  banking  as  such  to  be  practiced  by  bankers; 
it  vests  the  control  of  banking  in  the  hands  of  government  officers. 
The  theory  and  purpose  of  the  new  Act  are  widely  different  from 
those  of  the  Aldrich  bill.* 

Subject  to  a  great  deal  of  hostile  comment  by  the  financial 
and  business  press  during  the  period  of  its  discussion  before 
Congress,  after  passage  the  law  very  quickly  became  recog- 
nized at  its  true  worth  as  the  most  constructive  piece  of  legis- 
lation that  had  ever  been  placed  upon  the  American  statute 
books.  For  once,  at  least,  a  vitally  important,  though  technical, 
question  had  been  resolved  into  its  fundamental  issues  through 
public  discussion,  and  in  this  instance  a  measure  emerging 
into  law  did  represent  the  best  constructive  thinking  of  the 
nation. 

» H.  Parker  Willis,  The  Fc4ercfl  Referve,  p.  68. 


THE  FEDERAL  RESERVE  SYSTEM 


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S74         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

n.    ADMINISTRATIVE  FRAMEWORK  OF 
THE  SYSTEM 

The  Federal  Reserve  Act  divides  the  United  States  into 
twelve  districts,  chosen  in  the  light  of  commercial  rather  than 
geographical  factors.  The  map  on  page  573  shows  the  boun- 
daries of  the  twelve  districts  and  the  cities  in  which  are  located 
the  Federal  Reserve  banks  which  constitute  the  units  of  the 
system;  while  the  data  given  below  show  the  number  of  banks 
in  each  Reserve  district  and  the  paid-in  capital  and  siuplus 
of  each  Reserve  bank  in  1920. 

SIZE  OF  FEDERAL  RESERVE  DISTRICTS 


District 

Number  of 
Member  Banks 

Capital  of  Federal 
Reserve  Bank 

Surplus  of  I'ederal 
Reserve  Bank 

Boston 

432 

772 
688 
861 
601 
438 
1,394 
562 

972 

1,062 

8l2 

801 

(000  omitted) 
7,532 

24,677 
8,340 

10,162 
4,876 
3,841 

13,490 
4,266 
3,294 
4,314 
3,821 
6,395 

(000  omitted) 
12,351 
51,308 
13,069 

New  York 

Philadelphia 

Cleveland 

13,712 

Richmond 

8,067 

Atlanta 

7,050 

23,917 

5,884 

Chicago 

St.  Louis 

Minneapolis 

5,178 

Kansas  City 

8,395 
4,152 

Dallas 

San  Francisco 

11,662 

Total 

9,395 

95, 008 

164,745 

The  capital  of  the  Federal  Reserve  banks  was  subscribed 
by  the  member  banks  of  each  district,  each  bank  contributing 
a  sum  equal  to  6  per  cent  of  its  paid-up  capital  stock  and 
surplus.  While  capital  contributions  were  compulsory  for 
the  national  banks  that  joined  the  system,  it  was  optional  with 
each  bank  whether  or  not  it  should  join.  Only  in  one  sense 
was  there  any  compulsion;  a  national  bank  had  to  join  the 
system  if  it  remained  a  national  bank;  but  it  could  surrender 
its  charter  as  a  national  institution  if  it  so  desired  and  cither 
take  out  a  state  charter  or  suspend  operations.     All  of  the 


THE  FEDERAL  RESERVE  SYSTEM  57$ 

national  banks,  in  fact,  shortly  joined  the  system;  and,  as  we 
shall  later  see,  a  large  number  of  state  banks  have  since  become 
members. 

The  Federal  Reserve  hanks  are  managed  by  boards  of  directors, 
democratically  chosen,  and  representing  all  classes  of  interest. 
To  make  certain  that  the  Federal  Reserve  directors  shall 
represent  all  classes  of  opinion  and  interest,  the  law  provides 
that  one-third  of  the  board  of  nine  members  shall  be  known  as 
class  A,  one- third  as  class  B,  and  one- third  as  class  C  directors. 
The  class  A  directors  are  chosen  by  and  are  representative  of 
the  stock-holding  member  banks.  The  class  B  directors  must 
consist  of  individuals  who  at  the  time  of  their  election  are 
actively  engaged  in  their  district  in  some  commercial,  agri- 
cultural, or  industrial  pursuit.  The  class  C  directors  are 
selected  by  the  Federal  Reserve  Board,  which  is  in  effect  the 
representative  of  the  United  States  govermnent,  and  hence  of 
all  the  people.  One  of  these  directors  is  called  the  Federal 
Reserve  Agent  and  is  the  personal  representative  of  the  Federal 
Reserve  Board.  Although  the  directors  are  thus  chosen  from 
among  many  different  interests,  as  directors  they  must  act  as  a 
unit  and  in  the  interests  of  the  general  financial  welfare,  as  they 
see  it. 

Two  of  the  members  of  the  board  belonging  to  class  C, 
however,  act  in  a  dual  capacity.  The  Federal  Reserve  Agent 
and  deputy  Federal  Reserve  Agent  are  also  representatives  of 
the  Federal  Reserve  Board  and  have  certain  special  duties  to 
perform  in  this  capacity.^ 

In  still  another  way  the  Act  has  endeavored  to  secure  a 
democratic  organization  and  control.  To  insure  against  the 
domination  of  the  board  of  directors  by  the  larger  and  more 
powerful  banks,  the  law  provides  that  the  banks  shall  be 
divided  into  three  general  groups,  each  group  to  contain  roughly 
one-third  of  the  aggregate  number  of  member  banks  of  similar 
capitalization.  Thus  group  No.  i  would  contain  approximately 
one-third  of  the  total  number  of  banks  in  the  district,  consisting 
of  banks  of  the  largest  capitalization;    group  No.  3  would 

'  See  p.  580. 


576  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

include  the  smallest  banks  of  the  district;  and  group  No.  2 
the  banks  in  between.  Each  of  these  groups  of  banks  nomi- 
nates and  elects  one  class  A  and  one  class  B  director.  The 
directors  thus  represent  not  only  the  stockholding  banks, 
but  also  the  different  classes  of  banks. 

The  Federal  Reserve  Board  is  the  co-ordinating  and  controlling 
agency  of  the  system  as  a  whole.  This  board,  which  is  organ- 
ized as  a  part  of  the  Treasury  Department,  is  made  up  of  seven 
members,  of  whom  two  are  members  ex  officio — the  Secretary 
of  the  Treasury  and  the  Comptroller  of  the  Currency.  The 
other  five  members  are  appointed  by  the  president  by  and  with 
the  advice  and  consent  of  the  Senate.  It  is  provided  that  not 
more  than  one  member  of  the  board  may  come  from  a  single 
reserve  district;  and  that  at  least  two  of  the  presidential 
appointees  must  have  had  banking  or  financial  experience. 
No  member  of  the  board,  however,  may  be  an  officer,  director, 
or  stockholder  of  any  bank.  The  term  of  office  is  ten  years; 
and  the  board  is  a  perpetual  body  in  that  one  of  the  five 
appointed  members  retires  every  two  years.  Thus  during 
a  given  presidential  administration  not  more  than  two  of  the 
five  members  could  owe  their  appointment  to  the  president 
then  in  office.  The  president  is  empowered  to  name  one  of 
the  five  members  of  the  board  as  governor  and  another  as 
vice-governor,  and  these  are  the  chief  executive  officers  of  the 
entire  system. 

The  Federal  Reserve  Board  is  assisted  in  its  deliberations 
by  a  Federal  Advisory  Council  which  consists  of  one  repre- 
sentative from  each  Federal  Reserve  district  chosen  by  the 
board  of  directors  of  the  Federal  Reserve  bank  of  the  district. 
This  council  meets  quarterly  in  Washington  and  at  such  other 
times  and  places  as  it  may  choose.  Its  function  is  purely 
consultative;  it  is  designed  to  keep  the  Federal  Reserve  Board 
closely  in  touch  with  business  and  financial  conditions  in  all 
parts  of  the  country. 

The  powers  and  duties  of  the  Federal  Reserve  Board  in 
brief  are  as  follows:  It  may  suspend  or  remove  any  officer  or 
director  of  a  Federal  Reserve  bank;  it  may  suspend  a  Federal 


THE  FEDERAL  RESERVE  SYSTEM  577 

Reserve  bank  and  take  charge  of  it  for  the  purpose  of  reorgani- 
zation or  liquidation;  it  may  readjust  or  abolish  altogether 
the  classification  of  central  reserve  and  reserve  cities.  It  also 
has  power,  as  we  shall  later  see,  to  raise  or  lower  interest  rates, 
to  give  preference  to  certain  types  of  financial  operations, 
and  in  various  ways  to  modify  and  influence  financial  con- 
ditions. For  the  moment,  however,  we  are  not  concerned 
with  the  details  of  the  Federal  Reserve  Board's  operations,  the 
present  purpose  being  merely  to  show  the  general  relation  of 
the  board  to  the  system  and  to  note  that  it  is  a  co-ordinating 
and  controlling  agency,  in  ways  which  will  be  discussed  below. 

m.    PROVISION  OF  AN  ELASTIC  BANK-NOTE 
CURRENCY 

Among  the  defects  to  be  remedied  by  the  new  banking 
system  was  the  inelasticity  of  the  bond-secured  bank-note 
currency.  The  Federal  Reserve  Act  has  met  this  problem, 
not  by  a  complete  elimination  of  the  bond-secured  notes,  but 
by  the  creation  of  an  additional  form  of  note  currency — one 
secured  by  commercial  paper,  or  ''assets. "  Indeed,  as  a  result 
of  this  law  we  now  have  three  types  of  bank  notes  in  the  United 
States:  (i)  national  bank  notes  secured  by  government  bonds 
(as  before) ;  (2)  Federal  Reserve  bank  notes  (secured  by  govern- 
ment obligations);  (3)  Federal  Reserve  notes  (secured  by 
commercial  paper). ^  The  third  is  the  distinctly  new  form  of 
currency  and  the  one  which  is  designed  to  give  elasticity  to 
the  bank  note  system. 

I.  National  bank  notes.  During  the  period  when  the 
Federal  Reserve  bUl  was  before  Congress  it  was  suggested  that 
the  national  bank  notes  be  entirely  eliminated.  It  was  found 
difficult  to  accomplish  this,  however,  without  involving  heavy 
losses  to  the  banks  which  had  outstanding  bond-secured  cur- 
rency. The  2  per  cent  government  bonds,  which  were  chiefly 
used  as  security  for  the  national  bank  notes,  had  a  market 
value  substantially  equal  to  the  par  value  only  by  virtue  of 

« But  see  p.  584  for  qualifications  of  this  statement. 


578         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  fact  that  they  carried  the  circulation  privilege.  Taking 
away  from  the  bonds  this  privilege  would  have  meant  a  fall 
in  their  value  of  approximately  one- third ;  and  for  the  national 
banks  as  a  whole  this  would  have  involved  a  loss  of  over 
$200,000,000.  The  opposition  of  the  banks  to  the  proposal  to 
withdraw  the  circulation  privilege  from  the  2  per  cent  govern- 
ment bonds  was  so  vigorous  that  it  was  deemed  expedient  to 
adopt  some  other  means  of  securing  the  ends  desired. 

A  plan  was  finally  worked  out  whereby  a  gradual  retirement 
of  the  national  bank  notes  could  be  effected.  It  was  provided 
that  any  member  bank  which  desired  to  retire  any  or  all  of 
its  circulating  notes  might  sell  the  bonds  which  were  serving 
as  security  at  par,  through  the  intermediation  of  the  United 
States  Treasury,  to  a  Federal  Reserve  bank.  Under  this 
plan  the  funds  paid  over  to  the  Treasury  by  the  Federal  Reserve 
bank  which  purchases  the  bonds  are  used  to  redeem  the  out- 
standing national  bank  notes  that  have  been  secured  in  the 
past  by  these  bonds.  Any  balance  that  may  be  left  is  turned 
over  to  the  bank  in  question. 

The  law  sets  a  limit  on  the  amount  of  these  bonds  that  may 
be  purchased  by  a  reserve  bank  in  any  one  year;  and  if  every 
bank  should  take  advantage  of  its  option  to  rethe  notes,  it 
would  require  about  thirty  years  to  retire  the  total  amount 
outstanding  in  1914.  The  truth  of  the  matter  is  that  some 
banks  have  seen  fit  to  retire  their  national  bank  notes  by 
this  process,  while  others  have  not.  On  the  whole,  we  find 
that  the  total  quantity  of  national  bank  notes  outstanding 
was  $724,338,692  on  February  i,  1920,  as  compared  with 
$756,944,194  on  December  i,  1913.  Since  the  retirement  of 
the  notes  by  member  banks  is  not  mandatory,  it  is  altogether 
probable  that  we  shall  continue  to  have  a  large  volume  of  such 
notes  as  a  permanent  part  of  our  circulating  medium. 

2.  Federal  Reserve  bank  notes.  These  notes  owe  their  origin 
to  the  effort  to  provide  for  the  retirement  of  the  national  bank 
notes.  Although  all  the  Federal  Reserve  bank  notes  are  alike 
in  form  and  in  security,  they  originate  in  two  ways:  first,  the 
reserve  bank,  which  has  purchased  government  bonds  from  a 


THE  FEDERAL  RESERVE  SYSTEM  579 

member  bank  which  is  retiring  its  notes  (as  outlined  above), 
may  deposit  these  in  trust  with  the  Treasurer  of  the  United 
States  and  receive  an  amount  of  circulating  notes  equal  to  the 
par  value  of  the  bonds  thus  deposited.  This  amounts  merely 
to  transferring  the  issuing  of  bond-secured  notes  from  the 
individual  national  banks  to  the  Federal  Reserve  banks. 
Second,  the  reserve  banks  are  authorized  to  issue  additional 
notes  upon  the  secmity  of  additional  bonds,  on  the  same 
general  terms  that  national  banks  formerly  issued  such  notes, 
except  that  the  total  amount  is  not  limited  to  the  amount  of 
the  capital  stock  of  the  Federal  Reserve  bank  issuing  them. 
By  an  amendment  of  April  23,  1918,  these  notes  may  be  issued, 
in  any  denominations,  against  the  security  of  United  States 
certificates  of  indebtedness  or  one-year  gold  notes.  These 
provisions  obviously  make  possible  an  increase  in  the  total  of 
bond-secured  notes.  On  February  i,  1920,  the  total  volume  of 
Federal  Reserve  bank  notes  outstanding  was  $269,122,800. 

It  remains  to  be  noted  that  the  way  is  open  for  a  gradual 
retirement  of  these  Federal  Reserve  bond-secured  notes.  It  is 
provided  that  if  any  reserve  bank  desires  to  retire  outstanding 
bond-secured  notes,  the  bonds  which  serve  as  secmrity  may  be 
exchanged  at  the  United  States  Treasury  for  one-year  3  per 
cent  gold  notes  of  the  United  States,  which  do  not  carry  the 
circulation  privilege;  "to  an  amount  not  exceeding  one-half 
of  the  2  per  cent  bonds  so  tendered  for  exchange;  and  for 
thirty-year  3  per  cent  gold  bonds,  without  the  circulation 
privilege,  for  the  remainder  of  the  2  per  cent  bonds  so  tendered. " 
As  interest  rates  stood  in  1914  this  process  would  have  enabled 
the  Federal  Reserve  banks  to  get  rid  of  their  bond-secured 
notes  without  loss.  The  additional  i  per  cent  interest  charge 
would  of  course  fall,  immediately  speaking,  upon  the  govern- 
ment, and  ultimately  upon  the  tax-paying  public.  As  the 
figures  above  indicate,  however,  this*  privilege  has  not  been 
utilized;  and  in  view  of  the  great  changes  in  financial  con- 
ditions that  have  been  wrought  by  the  war,  we  shall  probably 
continue  to  have  an  expanding  rather  than  a  diminishing  total 
volume  of  Federal  Reserve  bank  notes. 


580         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

3.  Federal  Reserve  notes.  The  process  by  which  the  Federal 
Reserve  notes  which  are  designed  to  provide  the  elastic  element 
in  our  bank-note  system  are  issued,  and  the  regulations  govern- 
ing them,  can  best  be  shown  by  a  concrete  illustration.  Let  us 
assume  that  there  is  a  heavy  demand  for  additional  bank-note 
currency  with  which  to  move  Cna  crops  in  some  rural  community 
and  that  some  of  this  demand  is  manifested  at  the  First  National 
Bank  of  Ottumwa,  Iowa.  How  can  this  bank  expand  the 
volume  of  its  note  issues  ? 

It  is  provided  by  the  Federal  Reserve  law  that  a  bank 
desiring  to  issue  reserve  notes  may  do  so  upon  the  security  of 
commercial  paper  rediscounted  with  the  Federal  Reserve  bank 
of  its  district.  Accordingly,  the  Ottumwa  bank  indorses  over 
to  the  Federal  Reserve  Bank  of  Chicago,  say,  a  $10,000  promis- 
sory note  of  one  of  its  customers,  Mr.  Jones,  to  whom  a  com- 
mercial loan  has  been  made.  The  reserve  bank  of  Chicago 
will  give  the  Ottumwa  bank  Federal  Reserve  notes  equal  to 
the  face  value  of  Jones's  note  less  the  interest  for  the  time  which 
it. has  yet  to  run.  The  term  " rediscounting "  is  used  in  this 
connection,  to  indicate  that  a  note  which  was  originally  dis- 
counted by  a  member  bank  is  now  discounted  a  second  time. 
In  a  word,  the  Federal  Reserve  bank  thus  does  for  the  member 
bank  precisely  what  the  member  bank  does  for  its  customers — 
advances  the  face  value  of  the  note,  less  interest  until  maturity. 

Before  the  notes  can  be  issued  by  the  Federal  Reserve 
bank,  however,  the  promissory  note  that  has  been  received 
(or  other  notes  of  like  quality  and  amount)  must  be  placed  in 
the  custody  of  the  Federal  Reserve  Agent  of  the  Chicago  Federal 
Reserve  bank,  who,  it  will  be  recalled,  is  the  representative  of 
the  federal  government  on  the  directorate  of  the  Federal  Reserve 
bank.  This  agent  has  in  his  possession  Federal  Reserve  notes 
that  have  been  printed  in  advance;  and  upon  receipt  of  the 
commercial  paper  he  turns  over  to  the  Federal  Reserve  bank 
the  quantity  of  notes  demanded.  The  Federal  Reserve  bank 
then  sends  these  notes  to  the  Ottumwa  bank,  which  is  thereupon 
in  a  position  to  loan  them  to  the  individuq,ls  who  are  in  need  pf 
seasona.1  funds, 


THE  FEDERAL  RESERVE  SYSTEM  581 

It  will  make  for  clearness  if  we  consider  the  changes  that 
would  occur  as  a  result  of  this  operation  on  the  balance  sheet 
of  the  Ottumwa  bank  and  the  Federal  Reserve  Bank  of  Chicago 
respectively.  When  the  Ottumwa  bank  sends  its  customer's 
note  to  Chicago,  its  "Loans  and  discounts"  are  lessened  by 
the  amount  of  the  note.  The  "  Federal  Reserve  notes  "  received 
in  exchange  for  the  customer's  note  are  carried  as  assets  of  the 
Ottumwa  bank  until  such  time  as  they  are  loaned  to  a  customer, 
when  "Federal  Reserves  notes"  are  decreased  and  "Loans 
and  discounts"  are  increased  by  a  like  amount.  With  the 
Federal  Reserve  bank  the  rediscount  has  given  it  possession 
of  a  customer's  note,  which  is  carried  as  an  asset  under  "Redis- 
counts." The  "Federal  Reserve  notes"  issued  against  the 
security  of  this  commercial  paper  of  course  become  liabilities 
of  the  Federal  Reserve  bank. 

Thus  we  have  secured  an  expansion  of  bank  notes.  It  may 
be  noted,  moreover,  that  the  new  loan  which  the  Ottumwa 
bank  now  makes  gives  rise  to  a  new  customer's  note,  which, 
if  it  has  resulted  from  an  ordinary  commercial  operation,  is  also 
available  for  rediscount  with  the  Federal  Reserve  bank  of 
Chicago,  and  thus  may  also  be  used  as  a  basis  for  still  further 
issues  of  Federal  Reserve  notes.  Thus  as  long  as  there  con- 
tinue to  be  commercial  transactions  which  require  the  use  of 
borrowed  funds,  the  promissory  notes  arising  out  of  these 
transactions  will  provide  the  basis  for  the  additional  currency 
required  in  financing  them.  Here  is  the  same  sort  of  expansi- 
bility that  we  have  elsewhere  found  to  characterize  deposit 
currency. 

It  remains  to  consider  the  process  by  means  of  which 
Federal  Reserve  notes,  thus  issued,  are  reduced  in  volume 
when  the  need  for  them  is  past.  For  the  purpose  of  illustration 
let  us  consider  the  specific  $10,000  of  Federal  Reserve  notes 
that  were  put  in  circulation  by  the  Ottumwa  bank.  The 
individual  who  borrowed  these  notes  uses  them  in  meeting  his 
obligations,  and  the  individuals  who  receive  them  either  deposit 
them  directly  in  banks  or  use  them  in  the  payment  of  debts  to 
traders  and  others,  who  in  turn  send  them  to  their  banks  for 


582         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

deposit.  They  are  now  out  of  the  channels  of  circulation; 
but  they  have  not  been  returned  to  the  Federal  Reserve  Bank 
of  Chicago.     What  insures  their  return  to  their  source  ? 

We  have  seen  that  the  Ottumwa  bank  secured  funds  from 
the  Federal  Reserve  Bank  of  Chicago  by  the  rediscount  of  a 
promissory  note  of  Mr.  Jones,  one  of  its  customers.  At  the 
maturity  of  this  note,  it  will  be  sent  to  Mr.  Jones  for  payment, 
by  way  of  the  First  National  Bank  of  Ottumwa.  Jones  will 
pay  the  necessary  funds  over  to  the  Ottumwa  bank  in  whatever 
way  is  most  convenient  for  him.  And,  similarly,  the  Ottumwa 
bank  will  pay  the  Federal  Reserve  bank  in  whatever  way  is 
most  convenient.  Now  the  most  convenient  and  least  costly 
way  for  the  Ottumwa  bank  to  remit,  is,  in  fact,  by  sending  in 
any  Federal  Reserve  notes  which  it  has  on  hand,  for  the  reason 
that  the  law  do^s  not  permit  these  notes  to  be  counted  as  reserve. 
It  is  conceivable  that  all  of  the  notes  that  had  been  paid  out 
by  the  First  National  Bank  of  Ottumwa  might  meanwhile  come 
back  to  this  very  bank.  If  so,  the  Ottumwa  bank  might  send 
these  identical  notes  to  the  Chicago  Reserve  bank  in  settlement 
of  its  obligation  there. 

We  have  assumed  that  the  very  notes  which  had  been  paid 
over  to  Mr.  Jones  were  returned  to  the  Ottumwa  bank  in 
question.  It  does  not  matter,  however,  whether  the  identical 
notes  are  returned  to  this  bank,  or  not;  indeed,  the  notes  are 
exactly  alike  and  it  is  hence  impossible  to  differentiate  particular 
issues.  All  that  matters  is  that  $10,000  worth  of  Federal 
Reserve  notes  be  retm-ned  to  the  Federal  Reserve  Bank  of 
Chicago.  Some  of  them  may  be  notes  paid  out  by  other  banks 
in  Ottumwa,  or  by  banks  in  other  cities. 

Suppose  now  that  some  of  the  notes  issued  through  the 
Ottumwa  bank  should  find  their  way  into  a  national  bank  in 
Oskaloosa,  Iowa.  Will  they  then  be  returned  to  the  Chicago 
bank  for  collection?  The  answer  is  that  they  will,  for  the 
reason  that  whenever  it  has  occasion  to  make  payments  to 
the  Federal  Reserve  Bank  of  Chicago  (and  such  occasions  are 
constantly  arising)  the  Oskaloosa  bank  will  use  Federal  Reserve 
notes  for  the  purpose,  because  such  notes  are  not  available  as 


THE  FEDERAL  RESERVE  SYSTEM  583 

cash  reserve.*  It  does  not  matter,  therefore,  what  bank  in  the 
district  receives  them;  they  will  always  be  sent  in  payment  of 
obligations  to  the  bank  which  issued  them. 

It  is  possible,  however,  that  some  of  the  notes  that  have 
been  put  into  circulation  in  Ottumwa,  Iowa,  might  find  their 
way  into  banks  in  other  than  the  Seventh  Federal  Reserve 
district.  Concretely,  let  us  suppose  that  some  of  them  are 
sent  in  payment  of  obligations  to  the  First  National  Bank  of 
Akron,  Ohio.  Will  they  now  be  returned  to  the  Federal  Reserve 
Bank  of  Chicago  for  redemption  ?  They  will  not,  in  fact,  be 
sent  directly  to  Chicago,  for  the  Akron  bank  has  no  direct 
relations  with  the  Chicago  Reserve  institution.  The  Akron 
bank  will,  however,  send  these  notes  to  the  Federal  Reserve 
Bank  of  Cleveland,  whenever  it  has  payments  to  make  there, 
for  the  reason  that  Federal  Reserve  notes  can  never  be  counted 
as  reserve  in  any  member  bank  in  any  district.  When  these 
notes  arrive  at  the  Cleveland  Federal  Reserve  Bank,  they  may, 
however,  be  listed  as  assets  of  that  bank;  for  they  are  liabilities 
only  of  the  particular  reserve  bank  which  issued  them.  What 
now  is  to  prevent  the  Federal  Reserve  Bank  of  Cleveland  from 
again  putting  these  notes  into  circulation  and  thereby  prevent- 
ing their  redemption  at  the  source  of  issue  ? 

A  simple  provision  is  incorporated  in  the  law  which  insures 
their  being  sent  to  the  Federal  Reserve  bank  which  issued  them. 
It  is  provided  that  any  Federal  Reserve  bank  which  pays  out 
notes  of  other  reserve  banks  shall  be  subject  to  a  tax  of  10  per 
cent  of  the  value  of  the  notes  thus  paid  out.  Since  this  destroys 
the  profit  that  might  be  obtained  from  loaning  these  notes,  it 
insures  their  presentation  to  the  Reserve  bank  which  issued 
them,  in  payment  of  obligations  due  or  in  exchange  for  specie 

One  weakness  in  the  system  remains  to  be  noted — not  a 
weakness  in  the  Federal  Reserve  law  as  such,  but  a  weakness 
inherent  in  our  dual  banking  system.  Federal  Reserve  notes 
may  find  their  way  into  the  vaults  of  state  banking  institutions; 
and  since  state  banks  are  not  forbidden  by  law  to  count  Federal 

'  This  point  no  longer  holds,  however,  since  member  banks  under  an 
amendment  are  no  longer  required  to  keep  any  reserve  in  their  own  vaults. 


584         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Reserve  notes  as  reserve,  there  is  not  the  same  occasion  for 
sending  them  home  for  redemption  as  when  they  are  deposited 
in  national  institutions.  As  state  banks  in  increasing  numbers 
join  the  Federal  Reserve  System,  however,  and  subject  them- 
selves to  the  general  requirements  of  the  system,  this  weakness 
gradually  disappears.' 

Federal  Reserve  notes  are  not  based  exclusively  on  commercial 
paper.  In  the  foregoing  illustration  of  the  elasticity  of  Federal 
Reserve  notes  we  have  been  giving  the  impression  that  these 
notes  are  secured  exclusively  by  commercial  paper.  Such  is 
not,  however,  strictly  the  case,  although  the  theory  of  the  law 
was  imdoubtedly  to  make  such  paper  the  fundamental  basis 
of  the  elastic  note  currency.  Specifically,  the  law,  as  amended, 
makes  possible  the  issue  of  Federal  Reserve  notes  on  the  fol- 
lowing kinds  of  security:  (i)  paper  indorsed  by  member  banks 
and  drawn  for  strictly  commercial,  industrial,  and  agricultural  • 
purposes,  or  for  the  purpose  of  carrying  or  trading  in  securities 
of  the  United  States  government;  (2)  bills  of  exchange  indorsed 
by  a  member  bank  and  bankers'  acceptances  bought  by  the 
Federal  Reserve  bank  in  the  open  market;  (3)  gold  and  gold 
certificates.  Since  the  provisions  governing  paper  that  is 
eligible  as.  security  for  note  issues  are  in  the  main  identical  with 
those  governing  paper  that  is  eligible  for  rediscount  in  general, 
it  is  important  that  we  consider  carefully  at  this  place  the 
significance  of  these  provisions  from  the  standpoint  of  com- 
mercial banking  theory. 

I.  It  will  be  observed,  first,  that  the  provision  relating  to 
the  eUgibility  of  paper  as  security  for  note  issues  reads  "  drawn 
for  strictly  commercial,  industrial,  and  agricultural"  purposes. 
Thus  the  ordinary  narrow  technical  definition  of  "commercial,  ' 
as  involving  merely  the  purchase  and  sale  of  goods  by  middle- 
men, is  abandoned;  it  is  recognized  that  commercial  banking 
has  to  do  with  industry  and  agriculture  as  well  as  with 
commerce.* 

'  For  a  discussion  of  the  relation  of  state  banks  to  the  Federal  Reserve 
System,  see  pp.  733-37- 

'  Compare  this  with  the  discussion  of  commercial  paper  in  chap,  xxi, 
P-434. 


THE  FEDERAL  RESERVE  SYSTEM  585 

While  great  emphasis  is  placed  upon  the  essential  liquidity 
of  paper  growing  out  of  actually  completed  business  trans- 
actions, the  law  nevertheless  recognizes  that  paper  may  be 
eligible,  even  though  it  does  not  represent  a  completed  trans- 
action; for  it  defines  eligible  paper  to  include  cases  where  the 
proceeds  of  the  loan  have  been  used  or  "are  to  be  used"  for  the 
purposes  specified  in  the  act.  Thus  the  law  recognizes  the 
common  practice  of  making  loans  on  single-name  promissory 
notes  to  concerns  which  are  in  a  liquid  condition — that  is,  with  a 
satisfactory  excess  of  liquid  assets  over  current  liabilities — as 
legitimate  commercial  banking.  Eligible  paper,  therefore, 
need  not  be  secured  by  a  specific  stock  of  goods;  it  may  be 
secured  by  the  net  Uquid  assets  of  a  business  as  a  whole. 

While  the  law  thus  recognizes  the  current  banking  practice 
of  loaning  on  the  basis  of  the  general  standing  of  the  borrower, 
as  discussed  on  pages  377-84  above — ^it  does  not  recognize  the 
practice  of  annual  liquidation  of  the  borrower's  indebtedness; 
that  is,  the  practice  of  completely  paying  one's  debts  to  the 
bank  only  once  a  year.  Paper  to  be  eligible  for  rediscount  or  as 
security  for  note  issues  may  have  a  maturity  of  not  more  than 
ninety  days,  except  in  the  case  of  agricidtural  and  live-stock 
loans,  where  a  concession  from  the  short-time  principle  is  made 
by  permitting  for  a  limited  amount  of  paper  a  maturity  not 
exceeding  six  months.  The  limit  is  to  be  fixed  by  the  Federal 
Reserve  Board  at  some  definite  percentage  of  the  assets  of  the 
Federal  Reserve  bank  discounting  such  paper. 

In  the  second  place,  it  is  to  be  noted  that  paper  is  eligible 
as  security  for  note  issues  when  it  is  used  for  the  purpose  of 
carrying  or  trading  in  the  securities  of  the  United  States  govern- 
ment.' This  provision,  as  we  shall  later  see,  was  utilized  in 
striking  fashion  in  connection  with  the  floating  of  Liberty 
Loans  during  the  war.*  While  the  law  therefore  permits 
long-time  government  paper  to  be  used  as  security  for  note 
issues,  it  nevertheless  excludes  paper  drawn  for  the  purpose  of 
carrying  or  trading  in  stocks,  bonds,  and  other  investment 
securities,  in  the  belief  that  such  operations  are  subversive  of 

'  Cf.  p.  592.  '  See  pp.  628-30. 


586         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

sound  principles  of  commercial  banking,  that  they  do  not 
insure  the  necessary  liquidity  of  assets. 

2..  The  second  class  of  paper  available  as  security  for  note 
issues,  namely,  bills  of  exchange  indorsed  by  member  banks, 
and  bankers'  acceptances  bought  in  the  open  market,  are  of 
course  essentially  short-time  commercial  credit  instruments 
representing  ordinary  commercial,  industrial,  or  agricultural 
transactions. 

3.  The  authorization  of  gold  and  gold  certificates  as  col- 
lateral for  Federal  Reserve  notes  has  opened  the  way  to  a  very 
interesting  development.  When  notes  have  once  been  issued 
on  the  security  of  commercial  paper,  it  is  not,  in  fact,  necessary 
upon  the  maturity  of  the  commercial  paper  which  is  being 
held  as  security  by  the  Federal  Reserve  Agent,  that  a  like 
volume  of  Federal  Reserve  notes  should  be  retired  or  else  a 
like  volume  of  new  commercial  paper  be  turned  over  to  the 
Federal  Reserve  Agent;  for  the  notes  may  be  kept  in  circulation 
provided  the  Federal  Reserve  bank  turns  over  to  the  Federal 
Reserve  Agent  a  like  volume  of  gold  or  gold  certificates.  In  an 
endeavor  to  concentrate  the  gold  supplies  of  the  country  in 
the  central  reservoirs  provided  by  the  Federal  Reserve  banks, 
the  Federal  Reserve  Board  has  adopted  a  deliberate  policy  of 
exchanging  Federal  Reserve  notes  for  gold  and  gold  certificates, 
the  Federal  Reserve  notes  thereby  finding  a  wide  use  in  the 
channels  of  circulation  in  place  of  the  gold  and  gold  certificates 
which  they  displace.  This  process  of  substitution  has  been 
facilitated  by  virtue  of  the  fact  that,  although  the  Federal 
Reserve  notes  cannot  count  as  reserve  when  in  the  vaults  of 
either  Federal  Reserve  or  member  banks,  in  making  payments 
over  the  counter  and  in  meeting  the  needs  of  the  general  public 
for  circulating  media  they  are  quite  as  satisfactory  as  gold  or 
other  lawful  money. 

The  issue  of  Federal  Reserve  notes  in  exchange  for  gold  and 
gold  certificates  has  resulted  in  giving  to  the  Federal  Reserve 
banks  a  much  greater  power  of  note  and  credit  expansion 
than  would  otherwise  have  been  possible.  For  on  the  basis 
of  the  gold  secured  by  this  process  a  Reserve  bank  can  expand 


THE  FEDERAL  RESERVE  SYSTEM  587 

notes  by  two  and  one  half  times  the  volume  of  gold  on  hand  (the 
reserve  required  against  notes  being  40  per  cent),  and  nearly 
three  times  the  volume  of  deposit  currency  (the  reserve  required 
against  deposits  being  35  per  cent).  It  should  be  understood, 
in  this  connection,  that  the  gold  and  gold  certificates  exchanged 
for  Federal  Reserve  notes  and  held  by  the  Federal  Reserve 
Agent  still  coimt  as  reserves  against  outstanding  notes.  As  a 
result  of  this  pohcy  the  Federal  Reserve  notes  have  gradually 
supplanted  gold  and  gold  certificates  in  the  channels  of  cir- 
culation and  a  large  percentage  of  the  total  of  outstanding 
Federal  Reserve  notes  is,  in  fact,  now  secured  by  gold  and  gold 
certificates  instead  of  by  commercial  paper. 

This  policy  of  concentrating  the  gold  supply  of  the  country 
in  the  Federal  Reserve  banks  in  order  to  make  it  available  for  a 
larger  superstructure  of  credit  than  would  be  possible  if  it 
remained  widely  scattered  in  the  vaults  of  individual  banks, 
in  the  cash  tills  of  a  multitude  of  business  enterprises,  and  in 
the  pockets  of  innumerable  individuals,  was  largely  dictated 
by  a  consideration  of  the  enormous  financial  requirements  of 
the  war.  With  our  gold  resources  thus  efiFectively  mobilized, 
it  was  believed,  not  without  good  reason,  that  we  should  be 
able  to  meet  all  financial  demands  that  might  be  imposed 
upon  us.* 

It  is  urged  by  some  that  this  process  of  gradually  replacing 
the  gold  currency  in  circulation  by  Federal  Reserve  notes  has 
defeated  the  elastic  quality  of  such  notes.  While  there  is  no 
question  that  this  substitution  has  greatly  increased  the  power 
of  expanding  note  issues,  and  deposit  currency  as  well,  it  is 
not,  however,  generally  believed  that  it  has  destroyed  the 
contraction  feature  of  elasticity.  It  is  argued  that  the  notes 
will  return  to  the  issuing  bank  whenever  the  demand  for  cur- 
rency is  slack,  and  that  they  cannot  again  be  pushed  out  by  the 
Federal  Reserve  banks  until  a  new  currency  demand  has 
developed,  giving  rise  to  new  borrowings  by  member  banks 
from  the  Federal  Reserve  institutions.  It  should  be  noted, 
however,  that  there  will  be  times  of  great  business  activity, 

*  Cf.  chap.  xxvi. 


588         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

when  Federal  Reserve  notes  will  be  reissued  practically  as 
fast  as  they  are  redeemed.  The  total  quantity  may  steadily 
expand  for  a  considerable  interval  of  time,  and  again  it  may 
contract  for  a  period,  varying  with  the  season  of  the  year  and 
the  stage  of  the  business  cycle. 

Federal  Reserve  notes  are  adequately  secured.  In  the  effort 
to  give  Federal  Reserve  notes  an  elastic  quality,  the  question  of 
safety  has  not  been  overlooked.  Let  us  see  what  is  the  nature 
of  the  security  back  of  these  notes.  In  the  example  given 
above,  Mr.  Jones  had  given  his  promissory  note  to  the  Ottumwa 
bank.  Now  the  Ottumwa  bank  had  extended  the  credit  to 
Jones  on  the  strength  of  his  business  integrity  and  ability  and 
his  general  financial  standing.  There  is  thus,  first,  a  property 
security,  presumably  ample  to  insure  the  payment  of  the  loan 
by  Jones.  In  the  second  place,  there  is  additional  security  in 
that  the  Ottumwa  bank,  when  rediscounting  Jones's  note 
indorses  it  and  thus  becomes  secondarily  liable  for  its  payment. 
In  the  third  place,  the  Federal  Reserve  notes  are  the  liability 
of  the  Federal  Reserve  bank  which  issues  them;  and  as  such 
they  have  a  prior  lien  upon  all  of  the  bank's  assets.  Moreover, 
the  law  requires  that  for  every  $ioo  of  Federal  Reserve  notes 
issued,  the  Federal  Reserve  bank  must  hold  a  reserve  of  at 
least  $40  in  gold.  There  is,  finally,  a  double  liability  of  the 
stockholders  of  the  Federal  Reserve  banks;  and  since  the 
stockholders  of  these  institutions  are  none  other  than  all.  of 
the  member  banks  of  the  district,  it  will  be  seen  that  so  long 
as  the  banking  system  as  a  whole  does  not  crumble  to  pieces, 
Federal  Reserve  notes  will  not  fail  of  redemption. 

As  a  last  resort,  however — it  is  said  this  provision  was 
incorporated  to  please  Mr.  Bryan,  who  insisted  that  the  Federal 
Reserve  currency  must  be  equivalent  to  government  currency — 
the  Federal  Reserve  notes  are  the  direct  obligation  of  the 
United  States  government.  Thus  ultimately  all  the  taxable 
resources  of  the  nation  are  back  of  them. 

One  qualification  of  the  foregoing  statements  is  necessary, 
however.  The  Federal  Reserve  notes  that  arise  from  deposits  of 
gold  and  gold  certificates  with  the  Federal  Reserve  Agent  are 


THE  FEDERAL  RESERVE  SYSTEM  589 

not  secured  by  specific  commercial  paper.  Offhand  these  notes 
might  appear  to  be  backed  by  a  gold  reserve  of  100  per  cent; 
but  since  the  gold  that  is  deposited  in  exchange  for  them  is  also 
counted  as  reserve  against  notes  that  have  been  issued  on  the 
security  of  commercial  paper,  such  is  not  in  reality  the  case. 

Notes  issued  by  the  Federal  Reserve  banks  are  not  legal  tender. 
Neither  Federal  Reserve  bank  notes  nor  Federal  Reserve  notes 
have  been  given  legal  tender  power  in  the  settlement  of  private 
obligations — resembling  the  national  bank  notes  issued  by 
member  banks  in  this  respect.  Owing  to  the  provisions  regard- 
ing their  acceptability  and  redeemability,  however,  this  failure 
to  make  them  legal  tender  in  no  way  tends  to  impair  their 
serviceability  as  media  of  exchange. 

The  Federal  Reserve  bank  notes  are  a  direct  obligation  of 
the  Federal  Reserve  bank  which  issues  them.  They  are 
redeemable  at  the  United  States  Treasury  and  receivable  by 
all  national  banks  and  Federal  Reserve  institutions  as  well 
as  by  the  United  States  government  for  all  practical  purposes.^ 

The  Federal  Reserve  notes  are  redeemable  in  gold  coin  on 
demand  at  the  United  States  Treasury,  from  a  5  per  cent 
redemption  fund  provided  for  the  purpose,  and  at  any  Federal 
Reserve  bank.  They  are  receivable  at  par  by  all  national 
and  other  member  banks,  by  Federal  Reserve  banks,  and  for 
all  taxes  and  customs  and  other  public  dues. 

IV.    THE  CONTROL  OF  CREDIT 

A  fundamental  weakness  of  our  national  banking  system, 
as  we  have  seen,  was  the  lack  of  any  adequate  machinery  for 
the  control  of  credit,  or  deposit  currency,  and  hence  for  the 
control  of  business  in  general.  In  times  of  seasonal  strain 
trade  was  sometimes  halted  for  want  of  an  elastic  deposit 
currency;  in  years  of  great  industrial  activity  there  was  no 
effective  mea'^s  of  restraining  business  commitments  and 
preventing  thereby  the  development  of  conditions  of  acute 
crisis;   and  when  the  crisis  arrived,  there  was  little  chance  of 

'  The  provisions  here  are  exactly  the  same  as  with  the  national  bank 
notes;  see  p.  371. 


SQO        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

escaping  a  panic  for  the  reason  that  the  credit  structure  was 
rigid  and  inelastic.  The  problem  of  credit  control,  therefore, 
divides  itself  into  three  parts:  (i)  providing  the  requisite 
amount  of  funds  for  seasonal  business  requirements;  (2)  check- 
ing expansion  of  currency  during  the  upward  swing  of  the  busi- 
ness cycle  at  the  beginning  of  a  critical  business  situation; 
(3)  expanding  loans  in  time  of  acute  crisis  in  order  to  tide  the 
business  world  over  the  period  of  tension.  The  Federal  Reserve 
Act  has  attempted  to  meet  all  of  these  requirements. 

The  control  of  credit  imder  the  Federal  Reserve  System 
has  been  made  possible  largely  by  means  of  what  is  commonly 
termed  "the  mobilization  of  the  reserves"  of  the  banking 
system.  This  mobilization  of  reserves  has  been  effected  in  a 
variety  of  ways.  It  was  of  course  necessary,  first,  to  divert 
a  considerable  portion  of  our  monetary  supply  from  the  indi- 
vidual banks  to  the  Federal  Reserve  institutions.  This  was 
accomplished  in  part  by  requiring  each  member  bank  to  sub- 
scribe to  the  capital  stock  of  the  Federal  Reserve  bank  of  its 
district;  in  part  by  requiring  the  member  banks  to  keep  their 
lawful  reserves  with  the  Federal  Reserve  institutions;'  and  in 
part  by  exchanging  Federal  Reserve  notes  for  gold  and  gold 
certificates,  as  outlined  in  the  discussion  of  notes  in  the  section 
above.  Some  government  deposits  are  also  made  with  the 
Federal  Reserve  banks. 

The  use  of  our  monetary  supply  has  been  economized.  This 
great  concentration  of  reserves,  together  with  the  provisions 
for  their  effective  use  which  we  are  presently  to  consider,  have 
effected  in  the  first  place  a  great  economy  of  funds,  and  made 
possible  a  great  expansion  in  the  total  quantity  of  both  notes 
and  deposit  currency.  The  original  act  permitted  a  reduction 
in  the  reserve  of  member  banks  from  25  to  18  per  cent  in  the 
central  reserve  cities,  from  25  to  15  per  cent  in  the  reserve 
cities,  and  from  15  to  12  per  cent  in  the  country  banks.  But 
after  the  great  concentration  of  reserves  that  was  accomplished 
during  the  war  by  means  of  substituting  Federal  Reserve 

'The  original  law  required  only  part  of  the  reserve  to  be  so  kept,  but 
it  was  amended  later  to  include  the  entire  minimum  reserve. 


THE  FEDERAL  RESERVE  SYSTEM  591 

notes  for  gold  and  gold  certificates,  these  requirements  were 
still  further  reduced — to  13,  10,  and  7  per  cent  against  demand 
deposits  in  banks  in  central  reserve  cities,  reserve  cities,  and 
country  towns  respectively;  and  in  each  class  of  banks  3  per 
cent  was  required  against  time  deposits.  It  should  be  observed, 
however,  that  since  it  was  required  that  these  minimum  reserves 
should  be  kept  entirely  in  the  vaults  of  the  Federal  Reserve 
institutions,  money  for  till  money  purposes  constituted  an 
addition  to  these  minimum  reserve  requirements. 

Whether  or  not  this  economizing  of  reserves  constitutes  a 
real  gain  depends  upon  the  use  to  which  the  additional  credit 
thus  made  available  is  put.  There  was  a  tendency  among 
writers  on  the  Federal  Reserve  System  at  the  time  of  the 
passage  of  the  law  and  in  the  early  days  of  the  system's  operation 
to  attach  very  great  significance  to  this  conservation  of  funds; 
but  it  is  now  frequently  argued  that  the  great  expansion  of 
credit  that  it  has  made  possible  is  largely  responsible  for  the 
very  great  rise  in  prices  that  has  occurred  since  the  outbreak 
of  the  European  war.  However  this  may  be — and  it  is  a 
highly  controversial  issue — there  is  substantial  agreement 
that  the  chief  significance  of  the  concentration  of  reserves  in 
the  Federal  Reserve  institution  is  its  relation  to  an  effective 
control  of  credit  in  the  various  ways  suggested  above.  We  may 
therefore  now  turn  to  a  consideration  of  the  machinery  of 
credit  control  that  has  been  evolved. 

I.  Providing  the  requisite  amount  of  funds  for  seasonal 
business  requirements.  We  found  in  the  preceding  chapter  that 
in  times  of  great  seasonal  activity  the  volume  of  bank  reserves 
is  not  always  sufficient  to  permit  an  expansion  of  bank  loans 
and  thus  of  deposit  currency.  Under  the  Federal  Reserve 
System,  however,  it  is  always  possible  for  an  individual  baak 
in  need  of  funds  to  secure  them  from  the  Federal  Reserve  bank 
of  its  district  by  the  rediscount  of  commercial  paper  (but  see 
the  next  paragraph).  We  have  already  seen  that  such  redis- 
counts may  be  made  the  basis  for  an  issue  of  Federal  Reserve 
notes;  but  in  the  present  case,  instead  of  taking  notes,  which 
are  not  available  as  reserve,  the  member  bank  receives  a  deposit 


592         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

account  with  the  Federal  Reserve  bank  which  counts  as  cash 
in  hand,  and  this  serves  as  a  basis  on  which  additional  loans 
may  be  made.  So  long,  therefore,  as  member  banks  have 
paper  eligible  for  rediscount  and  so  long  as  the  Federal  Reserve 
banks  maintain  adequate  lending  power  through  keeping  large 
reserves,  there  can  never  be  any  possibility  that  the  supply  of 
deposit  currency  wUl  prove  inadequate  for  seasonal  needs. 

Collateral  loans  to  member  hanks  are  also  authorized.  Under 
the  original  law  the  Federal  Reserve  banks  could  extend  credit 
to  member  institutions  only  through  the  process  of  redis- 
counting  notes,  drafts,  bills  of  exchange,  etc.,  bearing  the 
indorsement  of  a  member  bank.  It  was  soon  found,  however, 
that  there  were  many  occasions  when  member  banks  would 
find  it  necessary  to  borrow  from  Federal  Reserve  banks  for 
very  brief  periods  of  time,  so  brief  that  it  was  inconvenient  to 
rediscount  customers'  paper  for  the  purpose.  An  amendment 
to  the  act  which  authorized  the  Federal  Reserve  banks  to  make 
short- time  loans  to  member  institutions  on  the  basis*  of  collateral 
security  was,  therefore,  passed  on  September  7,  1916.  The 
collateral  may  consist  of  notes,  drafts,  bills  of  exchange,  or 
bankers'  acceptances  that  are  eligible  for  rediscount,  or  of  bonds 
or  notes  of  the  United  States.  This  provision  has  been  exten- 
sively utilized;  in  fact,  during  the  war  by  far  the  largest  per- 
centage of  the  credit  extended  by  the  Federal  Reserve  banks  to 
member  institutions  was  made  on  the  basis  of  collateral,  con- 
sisting mainly  of  government  securities,  commonly  referred  to 
as  "war  paper. "^ 

Whereas  before  the  passage  of  the  Federal  Reserve  Act  the 
power  of  each  bank  to  expand  its  deposit  currency  depended 
upon  the  possession  of  unused  reserves  and  upon  its  ability  to 
secure  accommodations  from  other  banks,  now  no  bank  can 
fail  to  meet  the  demands  for  funds  in  its  community  merely  in 
consequence  of  the  exhaustion  of  its  individual  reserves  or 
because  of  its  inability  to  secure  assistance  from  some  corre- 
spondent bank.  The  central  reservoir  of  credit  that  exists  in 
tl.e  Federal  Reserve  banks  makes  it  possible  for  every  bank  to 

•  See  pp.  628-30. 


THE  FEDERAL  RESERVE  SYSTEM  593 

provide  the  necessary  loan  expansion  regardless  of  its  particular 
condition.  The  weak  links  in  the  banking  chain  are  thus 
immeasurably  strengthened  and  the  supply  of  credit  is  made 
responsive  to  seasonal  requirements.  Moreover,  after  the 
seasonal  strain  is  passed  such  deposit  currency  automatically 
contracts;  for  when  the  loans  which  were  procured  in  order  to 
finance  the  seasonal  requirements  are  paid,  checks  are  drawn 
against  deposit  accounts  in  favor  first  of  the  member  banks  and 
then  of  the  Federal  Reserve  institutions,  thereby  reducing  the 
volume  of  outstanding  deposit  accounts.  Such  deposits  will, 
moreover,  not  reappear  until  there  is  a  new  demand  for  funds 
to  be  used  in  connection  with  new  business  transactions. 

2.  Checking  expansion  of  currency  during  the  upward  swing 
of  the  business  cycle  at  the  beginning  of  a  critical  business  situation. 
This  aspect  of  the  problem  of  credit  control  involves  a  somewhat 
different  mechanism.  When  the  first  signs  of  stress  and  strain 
appear  within  the  system,  when  it  becomes  clear  that  further 
expansion  will  carry  in  its  train  an  inevitable  credit  collapse, 
it  is  beUeved  that  the  brakes  may  be  applied  to  industry  in 
such  a  way  as  to  cause  a  gradual  rather  than  a  precipitate 
readjustment  of  business  conditions.  Concretely,  the  instru- 
mentaUty  by  means  of  which  the  business  cycle  is  to  be  con- 
trolled is  the  interest  rate.  So  long  as  we  had  an  independent 
banking  system,  with  each  bank  acting  largely  on  its  own 
initiative,  it  was  impossible  to  secure  any  concerted  action  in 
the  control  of  the  discount  rate,  that  is,  in  raising  the  rate  as  a 
means  of  checking  business  expansion,  for  the  reason  that  it 
would  not  appear  to  the  interest  of  all  of  the  banks  to  raise 
interest  rates  and  thereby  lessen  loans.  Moreover,  an  agree- 
ment, if  adopted,  would  probably  raise  the  charge  that  the 
bankers  were  attempting  to  profiteer  at  the  expense  of  business 
generally.  Under  the  Federal  Reserve  System,  however,  a 
quick  raising  of  interest  rates  may  be  effected  through  the 
action  of  the  Federal  Reserve  Board,  which  cannot  well  be 
criticized  as  attempting  to  serve  profit-making  ends  of  its  own. 

The  means  by  which  the  Federal  Reserve  Board  may  secure 
a  general  increase  in  the  interest  rates  is  very  simple.    The 


594  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

board  is  given  the  power  of  fixing  the  rates  at  which  the  Federal 
Reserve  institutions  make  loans  to  member  banks,  as  also 
the  rates  which  they  shall  pay  when  loaning  funds  in  the  general 
market  through  the  purchase  of  acceptances,  etc.  At  a  time 
when  all  member  banks  are  finding  it  necessary  to  borrow 
from  Federal  Reserve  banks  fimds  with  which  to  meet  their 
customers'  demands,  a  raising  of  the  rates  at  which  they  borrow, 
promptly  results  in  the  raising  of  discount  rates  by  member 
banks  to  their  customers. 

The  result  of  this  raising  of  interest  rates  is  to  make  the 
conduct  of  business  more  costly,  to  narrow  the  margins  of 
profit,  and  hence  to  apply  the  brakes  to  further  industrial 
expansion  and  bring  about  a  gradual  readjustment.  In  a  word, 
it  is  believed  that  the  Federal  Reserve  Board,  acting  on  an 
understanding  of  the  phenomena  of  the  business  cycle,  could 
through  the  instrumentality  thus  placed  in  its  hands  exercise 
an  effective  control  over  general  business.  If  successful,  such 
a  policy  would  mean  that  the  last  stage  in  the  upward  swing 
of  the  business  cycle  would  be  eliminated,  and  with  it  of  course 
the  beneficent  results  of  such  a  period  of  very  active  business. 
But  on  the  other  hand,  it  would  prevent  a  financial  collapse 
such  as  occurred  in  the  past  when  business  was  allowed  to 
continue  its  rapid  expansion  to  the  ultimate  breaking-point, 
that  is,  to  the  point  of  complete  exhaustion  of  the  bank  reserves; 
and  it  would  bring  about  a  business  readjustment  more  gradual 
in  its  nature  and  hence  involving  less  serious  results  to  both 
capital  and  labor  than  would  be  the  case  if  the  upward  swing 
were  allowed  to  continue  for  a  longer  period,  even  though  an 
ultimate  financial  panic  might  still  be  avoided.' 

3.  Expanding  loans  in  a  period  of  acute  crisis.  In  the  event 
that  the  attempt  to  control  business  expansion  and  to  bring 
about  a  gradual  readjustment  by  raising  the  discount  rates 
should  prove  ineffective  and  business  should  continue  to  expand 
until  the  stage  of  acute  crisis  is  reached,  it  is  still  within  the 
power  of  the  Federal  Reserve  System  to  avoid  the  fourth  stage 

'  For  a  consideration  of  a  practical  test  of  this  method  of  controlling 
business  expansion,  see  the  chapter  which  follows,  pp.  634-40. 


THE  FEDERAL  RESERVE  SYSTEM  595 

of  the  business  cycle,  namely,  the  suspension  of  specie  payments 
and  the  collapse  of  the  entire  credit  structure,  accompanied  by 
financial  panic.  We  have  seen  in  the  preceding  chapter  that 
in  time  of  acute  crisis  the  outstanding  need  is  for  an  increase 
in  bank  reserves  and  an  expansion  of  loans.  The  Federal 
Reserve  System  is  designed  to  meet  this  need. 

Under  the  terms  of  the  law  it  was  provided,  as  we  have 
already  seen,  that  the  member  banks  should  contribute  to  the 
capital  stock  of  the  Federal  Reserve  institutions;  and  they  must 
also  keep  their  reserves  on  deposit  with  the  Reserve  banks. 
These  banks  thus  become  central  reservoirs  of  cash,  the  final 
repositaries  of  the  commercial  banking  system.  Upon  them 
we  have  placed  the  responsibiUty  of  maintaining  reserves 
adequate  for  all  emergencies.  While,  as  we  have  already  seen, 
the  law  prescribed  relatively  large  minima,  it  was  deemed  neces- 
sary as  a  matter  of  policy  for  the  Federal  Reserve  banks  to 
maintain  in  ordinary  times  reserves  greatly  in  excess  of  these 
figures  in  order  that  in  case  of  emergency  there  might  be  avail- 
able a  practically  "unlimited  amount"  of  lending  power.  It 
will  be  recalled  that  before  the  establishment  of  the  Federal 
Reserve  System,  our  decentralized  system  of  banking  led  each 
individual  bank  to  expand  its  loans  in  time  of  active  busine^ 
practically  to  the  reserve  limits;  there  could  be  no  concerted 
action  whereby  funds  might  be  set  aside  for  emergency  use  only. 
A  poUcy  of  providing  funds  for  emergencies  is,  however,  the 
very  essence  of  the  Federal  Reserve  System. 

To  understand  clearly  the  amount  of  expansion  that  is 
possible  in  time  of  emergency  and  the  way  in  which  it  is  prac- 
tically worked  out,  it  will  be  necessary  for  us  again  to  consider 
some  actual  transactions.  Suppose  in  time  of  crisis  the  First 
National  Bank  of  Chicago  has  a  demand  from  its  customers 
for  additional  loans.  While  its  reserve  is  down  to  the  minimum, 
it  may  make  the  additional  loans  by  first  taking,  say,  $100,000 
of  its  customers'  notes  to  the  Federal  Reserve  Bank  of  Chicago 
for  rediscount.  The  result  of  this  is  to  lessen  the  loans  of  the 
First  National  Bank  of  Chicago  by  $100,000  and  to  increase  its 
cash  reserve — in  the  form  of  a  deposit  account  in  the  Federal 


596  THE  FINANCIAL  ORGANIZATON  OF  SOCIETY 

Reserve  bank — by  $100,000,  less,  of  course,  the  amount  of  the 
interest  deducted  by  the  Federal  Reserve  bank.  On  the  basis 
of  this  new  reserve  the  First  National  Bank  can  now  make 
additional  loans  to  the  extent  of  over  $700,000  and  create  new 
deposit  accoimts  to  a  like  amount.* 

It  will  be  clear  at  once  that  so  great  an  expansion  of  lending 
power  as  here  suggested  would  be  adequate  to  meet  any  except 
the  most  extraordinary  credit  demands.  But  in  case  still 
further  demands  for  fvmds  are  manifested,  the  First  National 
Bank  could  take  the  $700,000  of  new  promissory  notes  that 
have  come  into  its  possession  as  a  result  of  its  additional  loans, 
and  rediscount  them  with  the  Federal  Reserve  Bank  of  Chicago, 
thereby  acquiring  additional  deposits  in  the  Federal  Reserve 
bank,  which  are  available  as  a  reserve  basis  for  still  fmrther 
loans.  So  long  as  there  is  eligible  paper  for  rediscount  and  so 
long  as  there  are  reserves  in  the  Federal  Reserve  banks  above 
the  minima  prescribed  by  law,  there  is  no  limit  to  the  expansion 
of  credit  that  can  be  made. 

The  system  of  rediscounting  strengthens  the  weak  links  in  the 
hanking  chain.  It  will  be  seen  that  under  this  system  the 
essentially  weak  links  in  the  banking  system  are  eliminated. 
Any  baiJc  within  the  First  Federal  Reserve  District,  for  instance, 
can  secure  loans  with  which  to  meet  the  demands  of  its  con- 
stituency regardless  of  its  own  condition  so  long  as  there  is 
money  in  the  central  reservoir  at  the  Federal  Reserve  bank. 
Rather  than  a  scramble  for  reserves  and  a  working  at  cross- 
purposes,  as  was  the  case  before  1914,  there  is  here  definite 
machinery  for  co-operative  action  in  meeting  credit  strains 
wherever  they  may  appear. 

Not  only  may  the  banks  of  District  No.  i  continue  to 
secure  accommodation  from  the  Federal  Reserve  bank  of  that 
district  so  long  as  its  reserve  is  not  exhausted,  but  the  Federal 
Reserve  Board  may  require  the  Federal  Reserve  bank  of 
District  No.  2  to  extend  loans  to  the  Federal  Reserve  bank  oi 
District  No.  i.    Thus  a  process  of  credit  expansion  can  continue 

'This  figure  is  possible  because  the  law  requires  a  reserve  of  onh 
13  per  cent  in  national  banks  in  central  reserve  cities. 


THE  FEDERAL  RESERVE  SYSTEM  597 

and  relief  can  be  given  to  individual  banks  and  through  them 
to  business  concerns,  until  the  average  reserve  of  all  the  Federal 
Reserve  banks  has  been  drawn  down  to  the  minimum.  Thus 
not  only  is  there  no  weak  link  within  a  district;  there  is  also  no 
weak  district  within  the  Federal  Reserve  System  as  a  whole. 
Each  is  as  strong  as  any  other. 

Finally,  the  reserve  requirements  are  not  irreducible  minima. 
For  the  law  makes  it  possible  to  cut  below  the  35  and  40  per 
cent  reserve  requirements  against  deposits  and  Federal  Reserve 
notes  respectively  in  case  of  acute  emergency.  The  Federal 
Reserve  Board  may  suspend  for  a  period  not  exceeding  thirty 
days,  and  from  time  to  time  may  renew  such  suspension  for  a 
period  not  exceeding  fifteen  days,  these  reserve  requirements, 
provided  it  establishes  a  graduated  tax  of  not  more  than  i  per 
cent  per  annum  upon  such  deficiency  of  reserves,  until  the 
reserve  falls  to  32^  per  cent;  and  if  they  fall  below  this  per- 
centage the  tax  shall  be  i|  per  cent  per  annum  upon  each  2I 
per  cent  or  fraction  thereof.  Thus  if  the  reserve  should  fall 
to  30  per  cent  there  would  be  a  tax  of  2I  per  cent;  if  it  fell  to 
29  per  cent  the  tax  would  be  4  per  cent;  and  if  it  fell  below 
27^  the  tax  would  be  5I  per  cent.  There  is  no  ultimate  limit 
other  than  zero.  Whether  a  decline  of  the  reserves  far  below 
the  legal  minimum  could  be  continued  without  a  loss  of  con- 
fidence leading  to  the  famiHar  hoarding  of  currency  and  ultimate 
collapse  of  the  credit  structure  is,  however,  open  to  some 
question.^  It  will  be  seen,  however,  that  these  provisions  do 
insure  a  very  high  degree  of  credit  flexibiUty. 

Control  of  the  interest  rate  is  also  of  aid  in  time  of  crisis. 
It  remains  to  observe  that  manipulation  of  the  interest  rate  may 
be  of  assistance  in  time  of  acute  crisis,  as  well  as  during  the 
earlier  stages  of  the  credit  strain.  In  case  of  a  failure  to  raise 
the  interest  rate  before  the  stage  of  acute  crisis  has  been  reached, 
or  in  the  event  that  such  increase  as  has  been  made  has  not 
sufl&ciently  applied  the  brakes  to  industry,  and  prevented 
the  development  of  acute  tension,  the  use  of  this  instrumentaUty 
of  credit  control  will  still  be  of  genuine  service,  in  two  ways. 

'  Cf .  p.  644- 


598  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

First,  the  raising  of  the  interest  rate  performs  an  important 
negative  function  in  discouraging  all  loans  that  can  be  done 
without.  While  it  is  highly  important  in  time  of  crisis  that 
every  borrower  who  is  in  a  sound  financial  condition  should  be 
"carried"  through  the  difficult  period  caused  by  the  disruption 
of  the  credit  structure  and  the  consequent  impairment  of 
mutual  credit  operations,  it  is  the  part  of  wisdom  to  raise  the 
discount  rate  to  a  very  high  figure  as  a  means  of  deterring  all 
borrowing  that  is  not  indispensable.  As  we  have  seen  in  the 
study  of  business  cycles,  it  is  imperative  that  a  temporary 
halt  be  called  to  new  commitments  and  a  period  of  readjustment 
brought  about.  Very  high  discount  rates  discourage  new 
commitments  and  promote  financial  readjustments. 

In  the  second  place,  the  raising  of  the  interest  rate  may 
perform  a  positive  function  in  attracting  additional  funds  to 
the  United  States.  In  our  study  of  the  mobilization  of  credit 
we  have  been  considering  up  to  this  point  only  the  internal  or 
domestic  financial  resources  of  the  nation.  We  shall  now  find 
that  through  the  control  of  the  discount  rate  the  way  has  been 
opened  imder  the  Federal  Reserve  System  to  attract  funds 
from  other  countries  in  time  of  acute  financial  strain.  High 
money  rates  in  the  United  States,  it  is  believed,  would  serve 
to  attract  funds  from  countries  with  low  interest  rates;  for 
money,  like  other  commodities,  tends  to  flow  to  the  regions 
where  the  return  from  its  use  is  highest.  European  central 
banks  have,  in  fact,  on  repeated  occasions  attracted  foreign 
funds  in  time  of  emergency  by  the  use  of  this  method.  If  the 
great  strain  is  felt  simultaneously  in  all  the  leading  commer- 
cial nations,  however,  and  if  the  central  banking  institutions 
of  all  of  them  should  resort  at  one  and  the  same  time  to  high 
interest  rates,  the  result  of  course  would  be  merely  a  stalemate. 
In  any  event,  however,  the  United  States  will  henceforth  be  in  a 
position  at  least  to  prevent  an  outflow  of  funds  at  a  time  when 
our  own  reserves  are  in  a  dangerous  condition. 

"Open  market  operations"  facilitate  the  control  of  credit. 
Thus  far  we  have  been  considering  the  Federal  Reserve  banks 
only  in  relation  to  their  dealings  with  "member  institutions  and 


THE  FEDERAL  RESERVE  SYSTEM  599 

with  one  another.  While  they  are  primarily  bakers'  banks, 
they  are  nevertheless  given  power  to  make  certain  direct 
investments — to  engage  in  what  are  known  as  "open  market 
operations."  These  operations  are  designed  both  to  give  the 
Federal  Reserve  banks  opportunity  for  engaging  in  profit- 
making  transactions  and  to  strengthen  their  control  of  the 
general  credit  system. 

Specifically,  every  Federal  Reserve  bank  is  empowered 

a)  To  deal  in  gold  coin  and  bullion  at  home  or  abroad,  to 
make  loans  thereon,  exchange  Feder.al  Reserve  notes  for  gold, 
gold  coin,  or  gold  certificates,  and  to  contract  for  loans  of  gold 
coin  or  bullion,  giving  therefor,  when  necessary,  acceptable 
security,  including  the  hypothecation  of  United  States  bonds 
or  other  securities  which  Federal  Reserve  banks  are  authorized 
to  hold. 

b)  To  buy  and  sell,  at  home  or  abroad,  bonds  and  notes 
of  the  United  States,  and  bills,  notes,  revenue  bonds,  and 
warrants  with  a  maturity  from  date  of  purchase  of  not  exceeding 
six  months,  issued  in  anticipation  of  the  collection  of  taxes  or 
in  anticipation  of  the  receipt  of  assured  revenues  by  any  state, 
county,  district,  political  subdivision,  or  municipality  in  the 
continental  United  States. 

c)  To  purchase  from  member  banks  and  to  sell,  with  or 
without  its  indorsement,  bills  of  exchange  arising  out  of  com- 
mercial transactions, 

d)  To  piurchase  and  sell  in  the  open  market  at  home  or 
abroad  either  from  or  to  domestic  or  foreign  banks,  firms, 
corporations,  and  individuals,  cable  transfers  and  bankers' 
acceptances,  and  bills  of  exchange  of  the  kinds  and  maturities 
by  this  Act  made  eligible  for  rediscount  with  or  without  the 
indorsement  of  a  member  bank. 

This  power  to  deal  in  gold  coin  and  bullion  at  home  and 
abroad  makes  it  possible  for  the  Federal  Reserve  banl^s  to  bid 
for  gold  at  the  weekly  auction  of  gold  in  London  or  elsewhere, 
and  thus  to  strengthen  our  own  gold  position  in  case  of  necessity . 
This  gold  may  be  paid  for  either  by  the  sale  of  securities  held  by 
the  Federal  Reserve  banks  or  by  means  gf  tlie  purchase  of  foreign 


6oo  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

bills  of  exchange.  The  borrowing  of  gold  on  acceptable  security 
is  also  designed  to  give  the  Federal  Reserve  banks  a  greater 
control  over  the  nation's  gold  supply,  by  preventing  an  outflow 
of  specie  at  critical  periods.  If  this  gold  is  borrowed  abroad 
it  will  give  rise  to  an  increased  supply  of  bills  of  exchange,  thus 
tending  to  prevent  the  rate  of  exchange  from  rising  to  the 
gold-exporting  point.  If  borrowed  in  the  United  States,  it  will 
result  in  a  shifting  of  gold  supply  from  the  member  banks  to 
the  Federal  Reserve  banks,  thereby  tending  to  raise  the  general 
discount  rate  in  the  United  States  and  thus  to  discourage  the 
export  of  specie.  Further  influence  upon  exchange  rates  may 
be  exerted  by  virtue  of  the  power  of  the  Federal  Reserve  banks 
to  buy  and  sell  foreign  bills  of  exchange  in  the  open  market  in 
Europe. 

The  provision  enabling  the  Federal  Reserve  banks  to  pur- 
chase and  sell  bills  of  exchange,  etc.,  as  listed  under  {d)  above, 
makes  it  possible  for  them  to  accomplish  two  important  results, 
aside  from  making  profits  for  themselves:  (i)  It  enables  them 
to  purchase  the  paper  of  banks  which  are  not  members  of  the 
Federal  Reserve  System  and  which  are  hence  not  in  a  position 
to  secure  needed  funds  through  the  process  of  rediscount  ing, 
thereby  materially  strengthening  the  general  credit  structure; 
(2)  it  enables  them  to  exercise  a  direct  influence  upon  interest 
rates  at  times  when,  owing  to  the  lack  of  applications  for 
rediscounts,  they  would  be  unable  to  influence  interest  rates 
through  the  ordinary  process.  But  by  virtue  of  their  power  to 
buy  paper  in  the  open  market  at  a  rate  either  higher  or  lower 
than  the  going  rate,  the  Federal  Reserve  banks  are  in  a  position 
to  set  the  pace  and  establish  such  new  rates  as  in  the  view  of 
the  Federal  Reserve  Board  are  demanded  by  the  situation. 

V.    THE  CREATION  OF  A  "DISCOUNT  MARKET" 

We  have  seen  in  the  two  preceding  sections  how  the  Federal 
Reserve  System  has  provided  a  degree  of  elasticity  in  our  bank 
note  and  deposit  currency  system  hitherto  unknown,  and  made 
possible  a  substantial  control  over  the  general  credit  and 


THE  FEDERAL  RESERVE  SYSTEM  60  r 

business  structure.  We  may  now  consider  how  the  development 
of  what  is  known  as  a  discount  market  gives  a  still  greater 
flexibility  to  the  commercial  banking  structure.  Since  the 
discoimt  market  is  based  upon  the  use  of  a  commercial  credit 
instrument  known  as  the  bank  acceptance,  a  description  of 
this  instrument  must  first  be  given. 

A  photographic  reproduction  of  a  banker's  acceptance  will 
be  foimd  on  page  166  above.  It  will  be  noted  that  it  is  a  bill 
of  exchange  drawn  by  an  individual  against  a  bank  and  accepted 
by  the  latter  for  payment  at  a  future  date.  It  differs  from  a 
bank  check  in  that  it  is  not  drawn  against  a  deposit  account 
and  is  not  an  order  to  pay  on  demand.  It  owes  its  origin,  like 
the  book  account,  the  promissory  note,  and  the  trade  draft, 
to  a  commercial  operation  involving  the  sale  of  goods  from 
AtoB. 

Let  us  suppose  that  A  in  Des  Moines  sells  goods  on  time  to 
B  in  Chicago.  He  may,  as  we  have  already  seen  in  chapter  xii,^ 
sell  on  open  account,  entering  the  amount  in  his  books  as  an 
account  receivable;  or  he  may  ask  B  to  give  him  a  promissory 
note;  or  he  may  draw  a  draft  upon  B  for  the  amount  and  send 
it  to  B  for  acceptance;  or  finally,  he  may  draw  a  draft  upon 
a  bank  designated  by  B,  who  makes  the  necessary  arrangements 
with  the  bank."  Now  if  the  Continental  and  Commercial 
National  Bank  of  Chicago  accepts  on  behalf  of  B  a  draft  drawn 
by  A,  it  is  in  a  sense  guaranteeing  the  credit  of  B.  It  is  not 
an  ordinary  guaranty,  however,  because  the  bank  assumes  a 
position  of  primary  liability:  it  does  not  bind  itself  to  pay 
in  case  B  fails  to  meet  his  obligations;  but  it  agrees  to  pay  on 
its  own  account. 

The  bank,  however,  looks  to  B  to  furnish  it  with  the 
funds  required  in  meeting  the  acceptance  before  the  date  of  its 
maturity.  It  will  be  apparent  that  if  B  makes  good  on  his 
agreement  to  put  the  bank  in  funds  before  the  acceptance  is  due, 

*  See  p.  162. 

*  We  have  already  touched  upon  the  principle  involved  in  the  bank 
acceptance  in  connection  with  the  study  of  the  part  that  commercial  banks 
play  in  financing  foreign  trade.    See  chap.  zz. 


6o2  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  bank  will  not  have  parted  with  any  money;  it  will  merely 
have  loaned  B  the  use  of  its  name,  for  which  service  it  receives 
a  small  commission  of  one-eighth  or  one-foiu-th  per  cent  of  the 
amount  of  the  acceptance.  A  bank  takes  some  risks,  however, 
for  the  reason  that  there  is  a  possibility  that  B  might  fail  to 
place  the  bank  in  funds  in  accordance  with  the  terms  of  his 
agreement.  The  bank,  however,  makes  a  careful  analysis  of 
B's  financial  standing  before  agreeing  to  accept  drafts  on  his 
behalf,  and  further  protects  itself  by  means  of  a  trust  receipt, 
such  as  was  discussed  above  in  the  chapter  on  "  Commercial 
Banking  and  the  Financing  of  Foreign  Trade"  (see  p.  415). 

Reference  to  the  liabilities  side  of  the  financial  statement 
on  page  365  indicates  that  the  Continental  and  Commercial 
National  Bank  of  Chicago  had,  in  fact,  on  that  particular  date 
incurred  liabilities  imder  Acceptances  of  $6,057,234.50;  while 
the  corresponding  item  on  the  assets  side  shows  that  customers 
had  assmned  a  liability  to  the  bank  for  a  like  amount.  It  will 
be  observed  by  reference  to  this  statement  that,  while  the 
practice  of  accepting  drafts  opens  up  a  new  source  of  profit 
to  the  banks,  it  does  not  increase  their  deposit  obligations  or 
lessen  the  ratio  of  cash  to  deposits. 

Since  an  accepting  bank  does,  however,  incur  a  liability 
and  since  there  is  always  some  chance  that  this  liability  may 
have  to  be  met  out  of  its  own  resources,  it  was  felt  necessary  to 
limit  the  volume  of  acceptances  that  might  be  made  by  any 
one  bank.  The  law  as  first  passed  permitted  the  making  of 
acceptances  only  in  connection  with  foreign  transactions — 
exports  and  imports;  but  through  a  subsequent  amendment, 
deemed  necessary  because  the  state  banking  law  of  New  York 
had  made  it  possible  for  state  banks  to  engage, in  the  acceptance 
of  domestic  as  well  as  foreign  bills,  the  national  banks  are 
now  permitted  to  make  domestic  acceptances.  It  is  provided, 
however,  that  no  bank  shall  accept  for  any  one  party  to  an 
aggregate  in  excess  of  10  per  cent  of  the  bank's  paid-up 
capital  stock  and  surplus,  unless  the  bank  is  secured  by  an 
attached  document  or  by  some  oth^r  actual  security  growing 
out  of  the  same  transaction  as  the  acceptance.    Moreover, 


THE  FEDERAL  RESERVE  SYSTEM  603 

the  total  volume  of  bills  that  may  be  accepted  by  any  one 
bank  at  one  time  shall  not  be  more  than  one-half  its  paid-up 
capital  stock  and  surplus;  although  the  Federal  Reserve  Board 
may  authorize  total  acceptances  up  to  100  per  cent  of  the 
capital  and  surplus,  provided  not  more  than  50  per  cent  of  the 
amount  are  domestic  acceptances. 

A  bank  acceptance  is  the  highest  form  of  credit  instrument 
for  the  obvious  reason  that  it  is  a  direct  obligation  of  a  large 
financial  institution  whose  practices  are  subject  to  careful 
regulation  and  control.  Accordingly  it  is  admirably  adapted  to 
serve  as  a  basic  credit  instrument  in  the  discount  market. 

For  a  terse  and  comprehensive  statement  of  the  nature  and 
function  of  the  discount  market  we  cannot  do  better  than  to 
reprint  at  this  place  a  statement  of  a  prominent  New  York 
banker.^ 

I.      FUNCTIONS  OP  A  DISCOUNT  MARKET 

a)  Regidating  medium  of  the  cash  and  investment  position  of 
banks. — ^The  most  important  function  of  a  discount  market  is  that 
it  operates  as  a  central  reservoir  of  commercial  credit  by  means  of 
which  individual  banks  may  regulate  their  investment  and  cash 
position.  The  discount  market  to  be  of  proper  use  must  be  of  suffi- 
cient breadth  that  a  bank  may  be  able  at  any  time  to  purchase 
therein  such  amount  of  bills  as  it  requires  to  properly  balance  its 
investment  and  cash  position,  with  the  full  assurance  that  it  can 
re-enter  the  market  as  a  seller  and  readily  dospose  of  such  bills 
without  materially  affecting  current  discount  quotations.  This 
naturally  necessitates  a  broad  market  in  which  a  large  volume  of 
bills  is  constantly  being  handled  and  which  can  readily  take  or 
furnish  a  substantial  quantity  of  bills  without  material  fluctuations 
in  its  rate  of  discount. 

h)  Equalizer  of  interest  rates  between  different  sections  of  the 
country. — ^A  broad  discount  market  operates  as  an  equalizer  of 
interest  rates  between  different  sections  of  the  country.  If  in  one 
district  the  banks  have  surplus  fimds,  their  purchases  of  bills  in  the 
discount  market  will  tend  to  keep  interest  rates  in  that  district  up 

» From  an  address  bj'  John  E.  Rovensky,vice-president  of  the  National 
Bank  of  Commerce  in  New  York,  published  in  the  Economic  World,  June  14, 
1919. 


6o4  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

to  the  level  of  the  other  districts.  In  like  manner,  if  in  a  district 
interest  rates  begin  to  rise  above  the  levels  of  the  other  districts, 
the  banks  of  that  section,  by  selling  their  holdings  of  bills  in  the 
discount  market,  would  tend  to  keep  interest  rates  approximately 
at  the  level  of  the  other  districts.  It  must  be  understood,  of  course, 
that  to  some  extent  inequalities  in  interest  rates  between  various 
districts  would  continue,  but  these  inequalities  would  not  be  as 
broad  as  they  are  at  present.  The  inequalities  would  be  limited  to 
such  minor  differences  in  interest  rates  as  the  average  bank  is  willing 
to  forego  rather  than  change  its  position  and  purchase  or  sell  bills  in 
the  market.  As  time  progresses  and  banks  become  more  accustomed 
to  deaUng  in  the  discount  market,  this  difference  would  tend  to 
become  quite  small. 

c)  Equalizer  of  interest  rates  between  the  United  States  and  foreign 
countries. — ^This  function  of  the  discoimt  market  Operates  very  much 
in  the  same  manner  as  in  the  case  of  equalizing  rates  between  different 
sections  of  the  same  country.  The  existence  of  a  broad,  healthy 
discount  market  in  the  United  States  would  encourage  foreign  banks 
to  pvirchase  our  bills  as  an  investment  when  interest  rates  in  this 
country  are  higher  than  abroad.  This  would  tend  to  move  our 
interest  rates  sympathetically  with  the  level  of  rates  the  world  over. 
Should  our  rates  decline  unduly,  there  would  be  a  tendency  on  the 
part  of  foreign  banks  to  dispose  of  their  holdings  of  American  bills 
and  on  the  part  of  our  banks  to  purchase  foreign  bills  and  dispose  of 
their  holdings  of  domestic  bills,  and  thus  a  movement  toward  re- 
establishing an  equihbrium  between  rates  here  and  abroad  would 
start.  This  does  not  mean  that  the  rates  here  and  abroad  would  be 
at  the  same  level,  but  it  does  mean  that  the  spread  between  rates 
here  and  abroad  would  ordinarily  not  be  as  far  apart  as  they  have 
been  in  the  past. 

d)  Stabilizer  of  gold  movements  between  countries. — ^This  function 
of  the  discount  market  is  really  an  after-effect  of  its  operation  as  an 
equalizer  of  interest  rates  between  different  countries.  Foreign 
bankers  would  grow  accustomed  to  having  in  their  portfolios  a  line 
of  American  bills  just  as  American  banks  have  at  times  lines  of 
foreign  bills.  As  exchange  rates  rose  in  this  country — which  means 
that  dollars  would  become  cheap  abroad — -foreign  banks  would 
increase  their  holdings  of  American  bills  on  account  of  the  cheap 
dollar  exchange  rate,  while  American  banks  would  sell  their  holdings 
of  foreign  bills  to  profit  from  the  high  foreign  exchange  rates.    Gold 


THE  FEDERAL  RESERVE  SYSTEM  605 

exports  would  thus  be  warded  off  for  a  time.  Gold  imports  would 
be  retarded  by  a  reversal  of  the  process. 

This  process  of  accumulating  a  portfolio  of  foreign  bills  in  time 
of  financial  ease  for  use  when  conditions  are  reversed  has  been  used 
successfully  by  the  central  banks  of  all  leading  European  countries 
and  may  profitably  be  utilized  by  our  Federal  Reserve  banks  when 
international  relations  again  become  normal.  I  do  not  mean  that 
international  movements  of  gold  would  be  stopped  by  the  operations 
of  our  discount  market,  but  it  is  certain  that  many  unnecessary  gold 
movements  would  be  prevented.  It  has  actually  occurred  in  the 
past  that  gold  shipments  in  opposite  directions  have  passed  one 
another  on  the  ocean.  In  other  words,  we  have  in  the  past  frequently 
exported  or  imported  gold  when  it  was  clearly  to  be  foreseen  that 
existing  conditions  were  but  temporary.  However,  it  was  not  the 
business  of  anyone  to  give  the  matter  any  thought  beyond  simply 
calcidating  whether  the  prospective  gold  shipment  yielded  a  profit, 
however  small.  We  had  no  stabilizing  mechanism  that  would  tend 
to  prevent  such  shifts  of  gold. 

e)  Stabilizer  of  interest  rate  levels  within  the  country. — Preventing 
unnecessary  exports  and  imports  of  gold  and  developing  a  closer 
relation  between  interest  rates  here  and  abroad  would  result  in  a 
greater  stability  of  American  interest  rates.  There  would  be  a 
closer  connection  between  the  American  reservoir  of  commercial 
credit  and  that  of  Europe.  Large  bodies  are  not  subject  to  sudden 
movements  to  the  same  extent  that  smaller  ones  are.  Interest 
rates  in  Europe  in  normal  times  are  much  steadier  than  ours;  discount 
rates  abroad  move  by  sixteenths  of  i  per  cent  and  on  the  whole  move 
within  narrow  limits. 

n.      THE  NECESSITY  OF  A  STANDARDIZED  INSTRUMENT  OF  CREDIT 
TO   THE   EXISTENCE   OF   A   DISCOUNT   MARKET 

The  truth  of  this  proposition  is  so  self-evident  that  a  lengthy 
explanation  is  not  necessary.  If  we  had  no  well-defined  standards 
in  grades  of  cotton,  deaUngs  on  the  Cotton  Exchange  would  be 
impossible.  The  same  holds  good  of  wheat,  oats,  corn,  or  any  other 
commodity.  Before  the  inauguration  of  the  Federal  Reserve  System, 
our  banking  system  lacked  a  standardized  credit  instrument,  and, 
therefore,  a  broad  discount  market  was  an  impossibihty.  The 
Federal  Reserve  Act,  by  introducing  the  bank  acceptance  into  our 
banking  mechanism,  has  furnished  us  the  instrument  we  lacked. 


6o6  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

In  a  bank  acceptance  the  clement  of  credit  risk  has  substantially 
been  eliminated  by  the  signature  of  a  bank  of  unquestioned  standing. 
The  acceptance,  therefore,  represents  absolute  safety  as  nearly  as 
can  be  attained  in  any  credit  instrument.  The  rate  of  discount  at 
which  such  instnmients  sell  in  the  market  simply  represents  the 
actual  value  of  the  use  of  the  money  and  not,  as  in  the  case  of  the 
discount  of  an  ordinary  promissory  note,  the  value  of  the  use  of 
money  plus  a  premium  for  the  credit  risk  assumed  by  the  loaner. 
In  every  commercial  country  in  the  world,  the  discount  market  is 
based  upon  the  bank  acceptance,  and  the  discount  market  in  turn  is 
the  basis  of  the  entire  money  market.  Our  brief  experience  since 
the  passage  of  the  Federal  Reserve  Act  justifies  the  opinion  that  our 
discount  market  will  likewise  be  based  upon  the  same  instrument — 
the  acceptance. 

m.      COMPONENT  FACTORS   OF  THE  DISCOUNT   MARKET 

The  component  factors  of  a  discount  market  consist:  first,  of 
the  accepting  banks  that  create  the  acceptance;  the  banks  and 
others  who  purchase  and  sell  acceptances;  the  central  banks  of 
rediscount  (in  our  case  the  Federal  Reserve  banks)  that  operate  as 
stabilizers  at  times  when  the  movements  of  the  discount  market 
represent  not  merely  the  usual  equalizing  of  the  investment  and 
cash  position  between  the  individual  banks  but,  rather,  a  condition 
that  is  general  throughout  the  country;  and  the  discount  corporations 
and  brokers  which  act  as  the  highly  essential  middlemen. 

a)  The  acceptance  hanks. — ^In  England  a  large  part  of  the  accept- 
ances are  created  by  the  so-called  acceptance  houses.  The  English 
deposit  banks  have  not  in  the  past  been  as  active  in  this  line  as 
those  of  France  and  Germany. 

Our  own  experience  leads  me  to  the  conclusion  that  the  deposit 
banks  in  this  country  will  be  the  main  creators  of  acceptances. 
There  is  no  vahd  reason  why  they  should  not  be;  in  fact,  it  is  to  be 
preferred  that  banks  operating  under  close  public  scrutiny  should 
be  the  creators  of  the  basis  of  our  discount  market  rather  than 
so-called  acceptance  houses,  the  standing  of  which  is  known  to 
but  few. 

b)  Bank  and  other  pttrchasers  and  sellers  oj  acceptances. — The 
purchasers  and  sellers  of  acceptances  constitute  the  active  discount 
market.  A  bank  that  is  a  purchaser  one  day  may  be  a  seller  the 
next.    Whether  a  bank  purchases  acceptances  or  sells  in  the  market 


THE  FEDERAL  RESERVE  SYSTEM  607 

should  depend  entirely  upon  its  own  individual  cash  and  investment 
position.  When  its  position  warrants  a  purchase  it  should  step  into 
the  market  and  acquire  the  bills  it  needs,  and  when  its  position 
changes  it  should  as  freely  sell. 

c)  The  central  rediscounting  bank. — ^The  central  rediscounting 
bank  in  our  country,  the  Federal  Reserve  bank,  should  operate 
as  a  stabilizer  in  cases  where  the  situation  becomes  one  that  is  not 
equalized  by  purchases  between  banks.  There  will  be  times  when 
a  preponderant  number  of  banks  throughout  the  coimtry  are  sellers 
of  acceptances.  At  such  times  the  Federal  Reserve  bank  should 
purchase,  imder  such  regulations  as  it  deems  wise,  either  from  the 
member  banks  or  direct  in  the  market,  a  certain  amoxint  of  bills. 
On  the  other  hand,  the  Federal  Reserve  bank  should  resell  such 
bills  when,  in  its  judgment,  market  conditions  justify  such  action. 

d)  Discount  corporations  and  brokers. — ^Discdunt  corporations 
and  other  bill  brokers  act  as  middlemen  between  the  various  factors 
of  the  discount  market.  They  perform  a  very  useful  function  and 
no  steps  should  be  taken  that  would  tend  to  curtail  their  usefulness. 
The  practice  of  banks  holding  their  own  bills  should  not  be  encour- 
aged. Likewise,  the  practice  of  banks  buying  one  another's  bills 
without  the  intermediation  of  a  broker  is  unsound  as  it  tends  to 
retard  the  development  of  the  market.  In  the  case  of  foreign  or 
domestic  acceptances,  it  matters  little  whether  the  accepting  bank 
or  the  holder  sells  the  bill  to  the  broker;  the  essential  part  is  that 
the  mediation  of  the  brokers  should  be  utilized  and  the  bill  should 
not  be  kept  off  the  market. 

The  practice  has  become  prevalent  in  this  country,  in  connec- 
tion with  domestic  acceptances,  of  the  accepting  bank  quoting  its 
customer  (the  drawer)  a  flat  interest  rate  which  includes  both  the 
rate  of  discount  and  the  acceptance  charge  and  itself  selling  the 
acceptance  to  the  broker.  So  long  as  the  bill  is  sold  to  a  broker 
who  in  turn  puts  the  bill  on  the  market,  there  can  be  no  objection 
to  this  practice,  as  the  bill  finds  its  way  into  the  open  market  and 
is  there  sold  to  such  banks  as  require  it. 

The  brokers  operate  not  only  as  middlemen  but  their  portfolios 
of  bills  constitute  the  floating  supply  without  which  a  stable  market 
would  be  impossible.  This  floating  supply  is  naturally  far  in  excess 
of  the  financial  resources  of  the  brokers  and  consequently  some 
means  must  be  available  to  them  of  borrowing  money  at  rates  that 
bear  some  relation  to  the  level  of  the  discount  market. 


6o8 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


There  follows  a  financial  statement  of  the  Discount  Cor- 
poration of  New  York,  which  was  established  under  the  invest- 
ment banking  laws  of  New  York  State  on  January  2,  1919. 
The  statement  of  condition  is  for  September  30,  1920. 


ASSETS 

Acceptances  Discounted 
U.S.  Government  Securities. 
Other  Government  Securities 
Cash  and  Due  from  Banks  . 
Sundry  Debits      .... 


LIABILITIES 

Capital $5,000,000.00 

Surplus 1,000,000.00 

Undivided  Profits      .     .  563,231.35 

Loans  Payable  and  Deposits      .     .     .     . 
Acceptances  Rediscounted 
and  Sold  with  Endorsement   .     .     .     . 

Unearned  Discoimt 

Simdry  Credits 


$51,768,359.45 

350,000.00 

985.00 

MI3.9I7-77 
8,759-68 

$53>S42,02i.90 


6,563,231.35 
19,987,100.72 

26,545,179-52 
308,115.58 

138,394.73 
$53,542,021.90 


VI.    CLEARINGS  AND  COLLECTIONS 

The  Federal  Reserve  System  has  efifected  some  noteworthy 
changes  in  our  clearing  and  collection  system.  While  not 
disturbing  the  process  of  clearing  worked  out  by  banks  in  a 
given  city  by  means  of  the  clearing-house  associations,  it  has 
materially  modiiied  the  system  by  means  of  which  out-of-town 
checks  are  collected,  and  it  has  introduced  a  new  clearings 
feature,  that  of  the  gold  settlement  fund  for  the  settling  of 
balances  between  the  Federal  Reserve  banks  themselves. 

It  will  be  recalled  that  under  the  old  system  of  collecting 
out-of-town  checks  the  correspondent  banks  in  reserve  and 
central  reserve  cities  were  utilized  for  the  purpose,  the  service 
being  performed  by  the  city  banks  as  partial  compensation  for 


THE  FEDERAL  RESERVE  SYSTEM  609 

the  use  of  the  reserve  and  other  funds'  which  were  currently 
deposited  by  country  institutions  with  their  city  correspondents. 
This  system  of  collection  was  in  many  respects  socially  uneco- 
nomical, often  involving,  as  we  found  in  chapter  xxii,  the  round- 
about routing  of  checks  and  long  delays  in  securing  the  funds. 
And  during  the  entire  period  that  a  check  was  in  transit,  the 
bank  which  had  cashed  it  was  counting  the  uncollected  item  as 
a  part  of  its  available  reserve.  The  "float,"  or  volume  of 
checks  in  transit  in  this  roundabout  process  of  collection,  was 
characteristically  very  large,  and  it  amoimted  to  a  substantial 
reduction  of  the  actually  available  reserves  of  the  banking 
system. 

The  old  system,  moreover,  often  proved  an  annoyance  and 
a  financial  burden  to  the  customers  for  whom  the  checks  were 
collected.  Collection  charges  were  typically  very  diverse  and 
often  appeared  to  be  arbitrarily  discriminatory.  For  want  of 
any  standards — aside  from  those  agreed  upon  in  some  of  the 
clearing-house  associations — many  banks  undoubtedly  charged 
excessive  rates,  while  others  did  not  even  cover  the  costs 
entailed. 

While  authority  was  given  by  the  Federal  Reserve  law  for 
the  introduction  of  a  new  clearing  and  collection  system,  the 
Federal  Reserve  Board  proceeded  very  slowly  in  the  formulation 
of  a  new  system,  for  the  reason  that  it  was  foreseen  that  a  thor- 
ough reorganization  of  collection  methods,  involving  losses  of 
collection  revenues  to  certain  banks  and  changed  relationships 
between  city  and  country  bank  correspondents,  would  arouse 
no  little  opposition.  The  Federal  Reserve  Board  therefore 
felt  its  way  carefully,  first  trjdng  out  a  voluntary  system  for 
the  member  banks  of  each  district;  and  it  was  not  until  July  5, 
1 9 16,  that  the  new  clearing  system  (compulsory  on  all  member 
banks)  was  put  into  operation. 

As  finally  evolved,  there  are  two  parts  to  this  Federal 
Reserve  collection  system:  (i)  intra-district  clearings,  and 
(2)  inter-district  clearings.  The  former  relates  to  the  col- 
lection and  clearing  of  checks  between  banks  in  the  same 
Federal  Reserve  district;   the  latter  to  that  between  banks  in 


6lO  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

different  Federal  Reserve  districts.    We  may  consider  each  in 
turn. 

1.  Infra-district  clearings.  Under  a  ruling  of  the  Federal 
Reserve  Board  every  Federal  Reserve  bank  is  required  to 
exercise  the  functions  of  a  clearing-house  for  its  members  and 
for  certain  qualified  non-member  banks,  known  as  "clearing 
member  banks."  Under  this  system  each  Federal  Reserve 
bank  is  to  receive  at  par,  that  is,  without  collection  charges, 
"checks  drawn  on  all  member  and  clearing  member  banks, 
and  on  all  other  non-member  banks  which  agree  to  remit  at  par 
through  the  Federal  Reserve  bank  of  tKeir  district."  The 
extension  of  the  "privilege"  to  non-member  banks  is  of  course 
designed  to  universalize  the  process. 

Under  this  plan  a  member  bank  in  Milwaukee,  which  receives 
a  check  drawn  on  a  bank  in  Springfield,  Illinois,  accepts  the 
check  from  its  customer  at  par  and  sends  it  to  the  Federal 
Reserve  Bank  of  Chicago,  which  in  turn  sends  it  directly 
to  the  member  bank  in  Springfield  for  collection.  Since  all 
banks  within  a  given  district  have  deposit  accounts  with  the 
Federal  Reserve  banks,  the  accounting  may  be  taken  care  of 
merely  by  debiting  and  crediting  the  accounts  of  member  banks 
at  the  Federal  Reserve  bank.  It  should  be  noted,  however, 
that  the  proceeds  of  the  check  are  not  made  available  for 
.  withdrawal  by  the  Milwaukee  bank  or  counted  as  a  part  of  its 
reserve  until  sufficient  time  has  elapsed  to  permit  it  to  be 
actually  collected  and  the  funds  returned  to  the  Federal  Reserve 
bank.  The  amount  of  time  that  must  elapse  before  it  can  be 
counted  as  reserve  varies  with  the  distance  of  the  bank  upon 
which  the  check  is  drawn  from  the  Federal  Reserve  bank 
which  is  collecting  it. 

2.  Inter-district  clearings.  The  system  of  inter-district 
clearings  is  a  necessary  complement  to  the  intra-district  clear- 
ings. Under  this  plan  every  Federal  Reserve  bank  receives 
at  par  checks  drawn  upon  any  bank  within  its  district  (whose 
checks  can  be  collected  at  par),  when  presented  by  banks 
outside  the  district.  That  is  to  say,  if  a  check  drawn  on  a 
Chicago  bank  is  cashed  by  a  bank  in  San  Francisco  it  will  be 


THE  FEDERAL  RESERVE  SYSTEM  6ll 

sent  to  the  Federal  Reserve  Bank  of  Chicago  where  it  will  be 
received  at  par  and  be  collected  from  the  bank  upon  which  it  is 
drawn.  The  San  Francisco  bank,  however,  does  not  itself 
send  the  check  to  the  Chicago  bank;  for  since  it  is  in  a  different 
reserve  district  it  has  no  direct  relation  with  the  Chicago  reserve 
institution.  It  therefore  sends  the  check  to  the  Federal  Reserve 
Bank  of  San  Francisco,  which  acts  as  agent  in  the  process  of 
collection.  Nor  does  the  Federal  Reserve  Bank  of  San  Francisco 
send  each  check  individually  for  collection  to  the  Federal 
Reserve  Bank  of  Chicago.  As  in  other  clearing  operations, 
counter  claims  largely  offset  each  other.  The  inter-district 
clearings  are  effected  through  a  system  of  offsets  at  the  Federal 
Reserve  Board  at  Washington,  involving  the  new  feature 
of  clearings  above  referred  to,  namely,  the  gold  clearance 
fund. 

Clearings  between  Federal  Reserve  banks  are  effected  by  means 
of  a  ''gold  clearance  fund."  The  Federal  Reserve  law  has 
required  each  Federal  Reserve  bank  to  forward  to  the  Treasury 
at  Washington,  or  to  the  nearest  sub-treasury,  for  credit  to  the 
account  of  the  gold  settlement  fimd,  under  the  administration 
of  the  Federal  Reserve  Board,  $1,000,000  in  gold  or  gold  cer- 
tificates, plus  an  additional  amount  equal  to  its  indebtedness 
at  the  moment  to  other  Federal  Reserve  banks.  At  10:00  a.m. 
eastern  time  each  bank  sends  a  telegram  to  the  Federal  Reserve 
Board  stating  the  amoimt  it  has  credited  to  other  Federal 
Reserve  banks  during  the  preceding  day.  Just  as  the  Federal 
Reserve  Bank  of  Chicago  now  effects  the  settlement  of  the 
daily  balances  of  Chicago  clearing-house  banks'  by  increasing  or 
decreasing  the  deposit  accounts  of  each  bank,  as  determined  by 
the  record  of  the  daily  clearings,  so  the  Federal  Reserve  Board 
adds  to  or  subtracts  from  the  accoimt  of  each  Federal  Reserve 
bank  in  the  gold  settlement  fund.  In  case  the  balance  of  any 
Federal  Reserve  bank  falls  below  $1,000,000,  it  must  be  immedi- 
ately replenished  by  sending  additional  gold  to  the  Treasury, 
It  should  be  added  that  the  balance  thus  maintained  by  each 
Federal  Reserve  bank  is  counted  as  a  part  of  its  legal  reserve, 

'  See  p.  461. 


6l2  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  establishment  of  this  gold  settlement  fund  has  rendered 
the  volume  of  money  that  needs  to  be  shipped  from  one  section 
of  the  country  to  another  almost  negligible  in  quantity.  The 
system  of  intra-  and  inter-district  clearings  has,  moreover, 
practically  eliminated  the  "float."  This  result  is  regarded  by 
many  as  the  greatest  achievement  of  the  system. 

The  cost  of  collecting  checks  was  originally  borne  by  the 
banks  which  were  receiving  the  benefit.  Each  Federal  Reserve 
bank  kept  a  record  of  the  cost  of  performing  the  service  and 
charged  the  amount  to  the  bank  for  which  the  service  was 
rendered,  the  usual  charge  being  one  and  one-half  cents  per  item. 
But  in  1918,  in  order  to  popularize  the  system  with  the  banks, 
all  service  charges  were  aboUshed.  This  move  rather  effectively 
silenced  the  opposition — except,  as  we  shall  see,  on  the  part  of 
certain  state  institutions. 

As  a  means  of  extending  this  collection  system  to  include 
state  institutions,  the  Federal  Reserve  banks  undertook — ^at 
the  time  the  compulsory  feature  for  member  banks  was  intro- 
duced— to  collect  for  member  banks,  and  for  such  state  banks 
as  had  voluntarily  joined  the  clearing  system,  checks  drawn 
on  any  state  bank  which  would  agree  to  remit  its  items  at  par. 
This"  many  state  banks  agreed  to  do.  All  banks,  whether 
member  or  non-member,  which  remitted  checks  for  collection 
at  par  were  henceforth  known  as  "par"  banks;  and  in  order  to 
facilitate  the  collection  of  checks,  the  Federal  Reserve  Board 
issued  a  monthly  supplement  to  the  Federal  Reserve  Bulletin, 
its  official  pubUcation,  giving  a  list — with  map — of  the  par 
institutions.  At  the  present  time'  the  par  banks  number  nearly 
28,000  out  of  a  total  of  29,768  commercial  banks  in  the  entire 
country. 

The  final  step  in  the  effort  to  universalize  this  collection 
system  was  inaugurated  early  in  1919.  Every  effort  was  made 
by  Federal  Reserve  officials  to  persuade  the  state  banks  volun- 
tarily to  agree  to  remit  their  checks  for  collection  at  par;  and 
during  the  year  about  6,000  banks  fell  into  line,  (These  are 
included  in  the  present  total  as  given  in  the  preceding  para- 

'  August,  1920. 


THE  FEDERAL  RESERVE  SYSTEM  613 

graph.)  The  Federal  Reserve  banks,  moreover,  resorted  to 
other  means  than  peaceful  persuasion;  for  as  soon  as  the  non- 
par banks  of  any  district  became  few  in  number,  the  Federal 
Reserve  bank  of  the  district  undertook  to  collect  at  par  checks 
drawn  on  all  the  banks  of  the  district,  whether  they  all  agreed 
to  remit  at  par  or  not.  This  was  to  be  accomplished  through 
the  instrumentality  of  a  local  agent — a  bank,  an  express  com- 
pany, or  a  suitable  person  or  corporation. 

This  attempt  to  coerce  state  banks  into  having  their  checks 
collected  at  par  has  met  with  stout  opposition.  In  the  South 
and  West  numerous  state  banks  have  steadfastly  refused  to 
remit  at  par,  and  resort  has  been  had  to  the  courts  to  test  the 
legality  of  the  Federal  Reserve  procedure.  The  basis  of  the 
opposition  is  primarily  a  pecuniary  one,  for — temporarily  at 
least — the  remission  of  items  at  par  entails  a  loss  to  the  par- 
ticular bank.  To  some  extent,  also,  the  opposition  is  a  reflection 
of  the  principle  of  state  rights  and  of  the  ancient  doctrine  that 
federal  interference  with  local  affairs  is  as  objectionable  as 
it  is  unwarranted. 

With  reference  to  the  question  of  the  losses  incurred  by 
local  banks,  it  should  be  understood  that  no  bank  is  denied 
the  right  to  make  a  "service"  charge  against  the  customers  for 
whom  the  checks  are  being  collected.  Many  banks,  in  fact, 
levy  such  charges;  while  others  prefer  to  assume  the  loss  as  an 
incidental  expense,  beHeving  that  this  method  has  compensa- 
tions in  promoting  the  good  will  of  customers.  All  that  is 
necessarily  lost  is  the  fee  formerly  charged  for  remitting  checks 
for  collection. 

The  ultimate  outcome  will  undoubtedly  be  a  universal 
free  collection  system.  The  statement  of  the  Federal  Reserve 
Board  that  "the  par  collection  system  is  not. a  local  or  selfish 
undertaking  for  the  benefit  of  member  banks,  but  is  a  national 
enterprise  for  the  convenience  of  the  pubHc  and  the  promotion 
of  commerce"  unquestionably  enunciates  a  sound  principle, 
and  the  temporary  pecuniary  interests  of  local  bankers  can  in 
the  end  hardly  stand  against  it. 


6i4  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Vn.  RELATION  OF  THE  TREASURY  TO  THE 
FEDERAL  RESERVE  SYSTEM 

In  our  analysis  of  the  operation  of  the  national  banking 
system  in  a  preceding  chapter,  attention  was  called  to  the 
relation  of  the  federal  Treasury  to  the  banking  and  credit  system. 
The  establishment  of  a  series  of  government  banks  under  the 
Federal  Reserve  law  has  made  it  possible  for  the  banking 
system  to  assist  the  Treasury  in  its  fiscal  operations  and  in 
general  for  the  Treasury  Department  to  work  in  harmony 
with  the  banking  and  currency  requirements  of  the  country. 
The  Federal  Reserve  Act  provides  that 

money  held  in  the  general  fund  of  the  Treasury,  except  the  s  per 
centum  fund  for  the  redemption  of  outstanding  bank  notes,  and  the 
funds  provided  in  this  Act  for  the  redemption  of  Federal  Reserve 
notes,  may,  upon  the  recommendation  of  the  Secretary  of  the 
Treasury,  be  deposited  in  Federal  Reserve  banks,  which  banks, 
when  required  by  the  Secretary  of  the  Treasury,  shall  act  as  fiscal 
agents  of  the  United  States;  and  the  revenues  of  the  government  or 
any  part  thereof  may  be  deposited  in  such  banks,  and  the  disburse- 
ments may  be  made  by  checks  drawn  against  such  deposits. 

The  Act  did  not,  however,  deny  to  the  Secretary  of  the  Treasury 
the  right  still  to  use  member  banks  as  depositaries  for  pubUc 
funds. 

The  Federal  Reserve  banks  have  in  fact  performed  a  very 
important  service  in  connection  with  the  fiscal  operations  of 
the  government.  Co-operating  with  the  federal  Treasury  in 
every  way,  they  largely  assumed  the  burden  of  managing  the 
huge  financial  operations  that  were  imposed  upon  the  govern- 
ment during  the  Great  War. 

As  yet,  however,  the  Treasury  Department  has  not  been 
completely  divorced  from  the  member  banks.  It  was  the  belief 
at  first  that  the  Federal  Reserve  institutions  would  rapidly 
displace  the  national  banks  and  the  sub-treasuries  as  depositaries 
of  government  funds;  but  war  conditions  served  to  prevent  the 
withdrawal  of  government  funds  from  individual  banks  for 
subsequent  deposit  in  the  Federal  Reserve  institutions.     The 


THE  FEDERAL  RESERVE  SYSTEM  615 

heavy  financial  requirements  of  the  war,  even  before  our 
entrance  into  it,  made  it  seem  unwise  to  withdraw  from  the 
banks  the  lending  power  which  was  given  to  them  by  virtue 
of  the  deposit  of  government  money.  It  was  felt  that  a  mini- 
mum disturbance  to  the  money  market  would  be  secured  if 
the  government's  funds  were  allowed  to  remain  widely  scattered 
and  kept  as  far  as  possible  in  the  banks  of  the  commimities 
where  the  government  received  its  funds.  In  consequence 
the  amount  of  government  deposits  has  increased  rather  than 
decreased  since  the  inauguration  of  the  Federal  Reserve  System. 
It  is  of  interest,  also,  that  the  law  authorized  the  deposit  of  the 
funds  derived  from  the  sale  of  the  Liberty  Bonds  and  certificates 
of  indebtedness  issued  during  the  war,  in  classified  state  banks 
and  trust  companies  as  well  as  in  national  institutions. 

The  way  has  been  opened  by  a  recent  act  of  Congress  for 
enlarging  the  responsibiUty  of  the  Federal  Reserve  banks  in 
connection  with  the  fiscal  operations  of  the  government.  The 
sub-treasury  system,  composed  of  nine  sub-treasuries  located 
in  dififerent  parts  of  the  country,  is  to  be  abandoned  on  July  21, 
1921,  and  its  work  will  be  taken  over  by  the  Federal  Reserve 
banks,  which  it  is  hoped  by  that  time  wiU  have  buildings  of 
their  own  and  vaults  adequate  for  the  purpose.  While  this 
act  does  away  with  the  sub-treasury,  it  does  not  insure  that  all 
government  funds  shall  be  kept  with  Federal  Reserve  rather 
than  with  member  banks. 

Is  the  Federal  Reserve  Board  under  the  domination  of  the 
Treasury  Department  ?  The  association  of  the  Federal  Reserve 
Board  with  the  Treasury  Department  has  given  rise  to  some 
criticism.  It  is  asserted  that  Treasury  fiscal  requirements 
have  dominated  the  policy  of  the  Federal  Reserve  Board  at 
times  when  banking  requirements  were  paramount  and  did 
not  run  parallel  with  Treasury  requirements.  Concretely, 
it  is  urged  that  the  desire  of  the  Treasury  Department  to  make 
a  record  in  floating  huge  Liberty  Loans  at  very  low  rates  of 
interest  was  responsible  for  the  policy  inaugurated  by  the 
Federal  Reserve  Board  during  the  war  and  maintained  until 
after  the  Victory  Loan  was  completed,  of  keeping  discount 


6i6 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


rates  at  a  very  low  level  and  hence  stimulating  speculation  and 
inflation  of  the  currency.  It  has  accordingly  been  vigorously 
urged  that  the  Federal  Reserve  Board  should  be  cut  loose  from 
the  Treasury  Department  in  order  tHat  it  may  exercise  its 
great  responsibilities  unhampered  by  the  views  of  the  Treasury 
or  by  considerations  of  political  expediency  for  the  party  in 
power.  It  is  unnecessary  to  enter  upon  a  discussion  of  the 
merits  of  the  contention  that  the  Federal  Reserve  policy  of 
maintaining  low  discount  rates  was  opposed  to  public  interest; 
it  is  enough  to  point  out  the  possibility  of  making  the  Federal 
Reserve  Board  subservient  to  the  Treasury. 


Vin.    FEDERAL  RESERVE  BANK  STATEMENTS 

The  following  combined  statement  of  condition  of  the 
Federal  Reserve  banks  on  February  4,  1916,  and  March  26, 
1920,  indicates  at  once  the  nature  of  the  Federal  Reserve  banks' 
operations  and  the  development  of  the  Federal  Reserve  System 
that  occurred  during  the  war  period. 

RESOURCES  AND  LIABILITIES  OF  THE  FEDERAL 
RESERVE  BANKS,  FEBRUARY  4,  1916 


RESOURCES 

Total  gold  reserve    .... 
Legal  tender  notes,  silver,  etc. 


Total  reserve    .     . 

Bills  discounted  and  loans: 
Maturities  within  thirty  days 
Maturities  within  sixty  days 
Maturities  within  ninety  days 

.    Over  ninety  days 


Total 


Investments 

Federal  Reserve  notes,  net . 
Due  from  Federal  Reserve  banks, 
All  Other  resources  .... 


Total  resources . 


net 


$342,004,000 

14,637,000 

$356,641,000 

17,355,000 

20,740,000 

10,391,000 

2,837,000 

$  61,323,000 

45,197,000 
33,710,000 
15,223,000 
11,903,000 

$513,997,000 


THE  FEDERAL  RESERVE  SYSTEM  617 

LIABILTTIES 

Capital  paid  in $  54,907,000 

Government  deposits 29,850,000 

Reserve  dep>osits,  net 419,137,000 

Federal  Reserve  notes,  net 9,966,000 

All  other  liabilities 137,000 

Total  liabilities $513,997,000 


RESOURCES  AND  LIABILITIES  OF  THE  FEDERAL 
RESERVE  BANKS,  MARCH  26,  1920 

RESOURCES 

Gold  and  gold  certificates $    154,237,000 

Gold    settlement    fund.    Federal    Reserve 

Board 363,132,000 

Gold  with  foreign  agencies 112,781,000 

Gold  with  Federal  Reserve  agents    .     .     .  1,186,829,000 

Gold  Redemption  Fund 117,776,000 

Total  gold  reserves $1,934,755,000 

Legal  tender  notes,  silver,  etc     ....  122,400,000 

Total  reserves $2,057,155,000 

Bills  discounted: 

a)  Secured   by   government   war.  obliga- 
tions   1,441,015,000 

b)  All  other  obligations 1,008,215,000 

Bills  bought  in  open  market 451,879,000 

United  States  government  bonds      .     .     .  26,797,000 

United  States  Victory  notes 68,000 

United  States  certificates  of  indebtedness  263,056,000 

Total  earning  assets $3,191,031,000 

Bank  premises ■   11,990 

Uncollected    items   and   other   deductions 

from  gross  deposits 768,788,000 

Five   per   cent    redemption    fund   against 

Federal  Reserve  bank  notes     ....  13,900,000 

All  other  resources .     .......  4,907,000 

Total  resources •   .  $6,047,771,000 


6l8         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

LIABILITIES 

Capital  paid  in $     91,059,000 

Surplus  fund 120,120,000 

Government  deposits 27,711,000 

Due  to  members — reserve  accoimt   .     .     .  1,867,125,000 

Deferred  availability  items 546,696,000 

Other  deposits,  including  foreign  govern- 
ment credits 100,160,000 

Total  gross  deposits $2,541,692,000 

Federal  Reserve  notes  in  actual  circulation  3,048,039,000 

Federal  Reserve  bank  notes,  net  liability  201,392,000 

All  other  liabilities 45,469,000 

Total  liabilities $6,047,771,000 


QUESTIONS  FOR  DISCUSSION 

L      THE  ORGANIZATION  OF  THE  SYSTEM 

1.  Draw  up  a  smnmary  statement  of  the  weaknesses  in  the  national 
banking  system  that  called  for  elimination. 

2.  Draw  up  a  summary  statement  of  the  chief  steps  in  the  progress 
of  banking  reform  legislation. 

3.  Study  the  map  of  the  Federal  Reserve  districts,  together  with 
the  table  showing  the  number  of  banks  in  each  district  and  the 
capital  and  surplus  of  each  Federal  Reserve  bank,  and  suggest 
any  district  changes  which  you  think  ought  to  be  made. 

4.  How  many  branch  reserve  banks  do  you  find?  Would  you 
suggest  any  additional  ones,  or  any  eliminations  ? 

5.  State  in  your  own  words  what  you  think  are  the  functions  of 
the  Federal  Reserve  Board.  In  addition  to  the  material  in  the 
text,  look  through  the  copies  of  the  Federal  Reserve  Bulletin  in 
the  library. 

6.  Enumerate  the  devices  that  have  been  adopted  to  insure  a 
representative  and  democratic  control  of  the  Federal  Reserve 
System. 

7.  What  is  the  purpose  of  the  Federal  Advisory  Council  ? 

8.  What  are  the  duties  of  the  Federal  Reserve  agent  of  each  Federal 
Reserve  bank  ? 


THE  FEDERAL  RESERVE  SYSTEM  619 

n.      THE  ELASTIC  BANK-NOTE  CURRENCY 

9.  Consult  the  table  on  page  103  and  note  the  relative  volume 
respectively  of  national  bank  note,  Federal  Reserve  bank  note, 
and  Federal  Reserve  note  currency. 

10.  What  inscription  is  found  on  the  Federal  Reserve  bank  notes  ? 
on  the  Federal  Reserve  notes  ? 

11.  What  was  the  reason  for  the  failure  of  the  Federal  Reserve  Act 
to  provide  for  the  complete  elimination  of  the  inelastic  national 
bank-note  currency  ?  What  is  the  explanation  of  the  provision 
of  the  new  form  of  inelastic  bank-note  currency  in  the  guise  of 
the  Federal  Reserve  bank  note  ? 

12.  What  is  it  that  gives  to  the  Federal  Reserve  notes  an  elastic 
quality  ? 

13.  It  is  crop-moving  period.  Show  by  a  concrete  illustration  how  a 
country  bank,  say  in  Ottawa,  Kansas,  could  procure  $5,000  of 
additional  bank  notes  for  the  needs  of  its  agricultural  constitu- 
ency. Indicate  the  changes  that  would  occur  on  the  balance 
sheets  both  of  the  member  bank  and  the  Federal  Reserve  bank. 

14.  Is  it  necessary  for  the  particular  notes  which  have  been  issued 
for  an  emergency  to  be  retired  in  order  to  secure  the  necessary 
contractility  ? 

15.  Show  what  changes  would  occur  on  the  balance  sheets  of  the 
First  National  Bank  of  Ottawa,  Kansas,  and  of  the  Federal 
Reserve  Bank  of  Kansas  City  when  $5,000  of  Federal  Reserve 
notes  are  retired. 

16.  Draw  up  a  statement  in  outline  form  showing  the  security  back 
of  the  Federal  Reserve  notes. 

17.  What  different  kinds  of  bank  assets  are  eligible  as  security  for 
Federal  Reserve  notes  ? 

1 8.  Show  by  a  concrete  illustration  how  the  provision  which  permits 
gold  and  gold  certificates  to  be  exchanged  with  the  Federal 
Reserve  agent  for  Federal  Reserve  notes  expands  the  loaning 
capacity  of  Federal  Reserve  banks. 

in.      THE  CONTROL   OF  CREDIT 

19.  Indicate  how  the  Federal  Reserve  System  mobilized  or  con- 
centrated the  financial  resources  of  the  country. 

20.  "By  virtue  of  the  improved  organization  of  our  banking  and 
credit  machinery  which  the  Federal  Reserve  System  has  made 


620         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

possible,  the  banks  are  enabled  to  conduct  their  operations  with 
safety  on  a  much  slenderer  margin  of  reserves. "  Explain  why 
this  is  so. 

21.  How  much,  in  fact,  have  reserves  been  reduced  under  the  Federal 
Reserve  System  ? 

22.  What  will  determine  whether,  in  the  case  of  a  seasonal  demand 
for  funds,  rediscounting  operations  with  the  Federal  Reserve 
bank  will  result  in  the  creation  of  Federal  Reserve  note  or  of 
deposit  liabilities  ? 

23.  When  a  member  bank  has  occasion  to  borrow  from  a  Federal 
Reserve  bank,  what  will  determine  whether  it  will  rediscount 
the  commercial  paper  of  its  customers  or  borrow  on  its  own 
promissory  note  with  commercial  paper  or  government  securities 
as  collateral  ? 

24.  Might  a  member  bank  in  need  of  funds  secure  ihem  indirectly 
from  the  Federal  Reserve  bank  by  selling  bankers'  acceptances 
in  the  open  market,  the  Federal  Reserve  banks  being  the 
purchasers?     (See  balance  sheet  on  p.  617.) 

25.  Do  you  think  it  makes  any  difference  from  the  standpoint  of 
banking  safety  or  the  liquidity  of  assets  which  method  a  member 
bank  uses  in  borrowing  from  the  Federal  Reserve  banks  ? 

26.  What  provisions  of  the  Federal  Reser\'e  Act  are  designed  to 
enable  the  Federal  Reserve  banks  to  check  undue  expansion  of 
business  during  the  upward  swing  of  the  business  cycle  ? 

27.  "  Raising  the  rates  of  discount  has  both  a  negative  and  a  positive 
effect  on  financial  conditions. "    What  are  these  effects  ? 

28.  Do  you  think  the  control  over  the  rate  of  interest  is  intended 
for  use  mainly  in  time  of  acute  tension  ? 

29.  It  is  a  period  of  acute  crisis.  Bank  A  in  Kokomo,  Indiana,  has 
in  its  portfolio  $10,000  of  eligible  commercial  paper  which  it  had 
discounted  on  August  1,  at  7  per  cent,  the  date  of  maturity  being 
November  i.  On  September  15  this  paper  is  rediscounted  with 
the  Federal  Reserve  Bank  of  Chicago  at  8  per  cent.  The  paper 
is  paid  at  maturity  by  the  customer  of  the  Kokomo  bank.  Make 
the  necessary  changes  on  the  balance  sheets  (a)  of  the  Kokomo 
Bank,  both  when  the  loan  is  made  and  when  it  is  paid;  (b)  of 
the  Federal  Reserve  Bank  of  Chicago,  both  when  the  rediscount 
is  made  and  when  the  obligation  is  liquidated.  Assume  that 
these  transactions  do  not  involve  the  use  of  Federal  Reserve 
notes. 


THE  FEDERAL  RESERVE  SYSTEM  62 1 

30.  To  what  extent  could  the  Kokomo  bank  expand  its  loans  as  a 
result  of  the  rediscount  operations  suggested  in  the  preceding 
question  ? 

31.  What  is  the  limit  to  the  expansion  of  deposit  currency  through 
the  process  of  rediscounting  (a)  so  far  as  any  single  bank  is 
concerned;  (b)  so  far  as  aU  the  banks  of  a  given  district  are 
concerned;  (c)  so  far  as  all  the  banks  of  the  United  States  are 
concerned  ? 

32.  Draw  up  a  summary  statement  showing  how  the  Federal  Reserve 
System  strengthens  the  weak  links  in  the  banking  chain. 

33.  "The  significant  feature  of  the  Federal  Reserve  Act  is  that  it 
transfers  the  responsibility  for  maintaining  adequate  reserves 
for  emergencies  from  the  privately  owned  banks  of  the  financial 
centers  to  the  governmentally  controlled  Federal  Reserve  insti- 
tutions."  Show  in  what  ways  this  is  advantageous  from  the 
standpoint  of  banking  control. 

34.  "The  Federal  Reserve  System  is  panic  proof.  Therefore  there 
is  no  occasion  for  anyone  to  urge  that  business  expansion  must 
be  checked  in  order  to  prevent  a  financial  collapse."  Do  you 
agree  with  this  statement  ? 

35.  If  you  were  a  member  of  the  Federal  Reserve  Board,  what  policy 
would  you  favor  adopting:  (a)  during  a  period  of  depression; 
(b)  during  the  early  stages  of  the  upward  swing  of  a  business 
cycle;  (c)  at  the  beginning  of  a  critical  period;  (d)  at  a  time  of 
acute  financial  tension  ? 

36.  In  what  ways  may  the  Federal  Reserve  Board  exercise  control 
over  the  credit  situation  through  "open  market  operations"? 

37.  Sell  a  bill  of  goods  for  $10,000  to  Mr.  Jones  in  New  York,  and 
draw  a  bank  acceptance  for  the  amount  and  discount  it  at  your 
local  bank.  Show  what  changes  would  occur  on  the  balance 
sheet  of  the  accepting  bank  and  of  the  bank  which  discounts  the 
acceptance. 

38.  Show  concretely  how  a  bank  acceptance  is  profitable  to  (a)  the 
accepting  bank;  (b)  the  person  for  whom  the  acceptance  is 
granted;  (c)  the  seller  of  the  goods;  (d)  the  bank  which  discounts 
the  acceptance. 

39.  What  is  meant  by  a  discount  market  ?  Is  it  in  any  sense  com- 
parable to  a  stock  market  ? 

40.  If  the  Federal  Reserve  banks  are  always  able  to  rediscount  the 
commercial  paper  of  member  banks  or  lend  them  funds  on 
collateral  security,  why  is  it  still  necessary  for  a  member  bank 


622  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

alwa3rs  to  have  access  to  an  open  discount  market  where  it 
can  sell  acceptances,  etc.  ? 

41.  What  is  the  relation  of  the  bank  acceptance  to  the  development 
of  a  discount  market  ? 

42.  What  is  the  purpose  of  the  acceptance  banks  of  Eurojie?  Are 
such  institutions  indispensable  to  the  development  of  a  discount 
market  ? 

43.  Why  is  it  beUeved  that  the  growth  of  discoimt  corporations  or 
brokers  is  necessary  to  the  efl&cient  operation  of  a  discount 
market  ? 

IV.      CLEARINGS  AND   COLLECTIONS 

44.  What  parts  of  the  clearing  and  collection  sj^stem  have  been 
affected  by  the  Federal  Reserve  System  ? 

45.  What  was  the  objection  to  the  "float"  that  characterized  the 
former  collection  system  ? 

46.  A  bank  in  Grand  Rapids,  Michigan,  receives  a  check  from  one 
of  its  customers  drawn  against  a  bank  in  Milwaukee,  Wisconsin. 
Show  how  it  would  be  collected  under  the  Federal  Reserve 
clearing  system.  How  would  it  probably  have  been  collected 
under  the  old  system  ? 

47.  A  bank  in  Springfield,  Massachusetts,  receives  a  check  drawn 
on  a  bank  in  St.  Louis,  Missouri.  Show  how  it  would  be  col- 
lected under  the  Federal  Reserve  System.  How  would  it  prob- 
ably have  been  collected  under  the  old  system  ? 

48.  What  is  the  purpose  of  the  gold  settlement  fimd?  In  what 
respect  is  it  analogous  to  the  system  of  settling  clearing-house 
balances  by  means  of  clearing-house  certificates?  In  what 
respects  does  it  differ  ? 

49.  Have  the  state  banks  not  a  right  to  oppose  their  attempted 
coercion  into  the  Federal  Reserve  clearing  system  ? 

50.  Do  you  think  that  in  the  end  all  of  the  banks  will  find  it  to  their 
advantage  to  use  the  system  of  par  collections?  Why,  or 
why  not  ? 

V.      THE   TREASURY   AND  THE  FEDERAL  RESERVE   SYSTEM 

51.  Why  did  not  the  Federal  Reserve  System  eliminate  the  system 
of  depositing  government  funds  with  individual  depositary  banks  ? 

52.  Would  you  favor  the  abolition  of  the  system  of  depositing 
government  funds  in  individual  banks  ?      Why,  or  why  not  ? 

53.  How  does  the  Federal  Reserve  System  make  possible  the  elinU- 
nation  of  the  sub-treasury  system  ? 


THE  FEDERAL  RESERVE  SYSTEM  623 

54.  Would  you  favor  severing  the  relation  of  the  Federal  Reserve 
banks  with  the  Treasury  Department,  including  the  elimination 
of  the  Secretary  of  the  Treasury  as  a  member  of  the  Federal 
Reserve  Board  ? 

55.  As  a  member  of  the  Federal  Reserve  Board  in  time  of  war,  would 
you  take  the  stand  that  Federal  Reserve  policy  should  be  formu- 
lated without  regard  to  the  fiscal  problems  of  the  Treasixry 
Department  ? 

VI.      ANALYSIS   OF  FEDERAL  RESERVE  BANK  STATEMENTS 

56.  What  are  the  most  significant  changes  in  the  combined  financial 
statements  of  the  Federal  Reserve  banks  in  19 16  and  in  1920, 
as  given  on  pages  616-18  ? 

^7.  Under  what  designation  do  "rediscounts"  appear  in  the  balance 
sheet  on  page  617  ?    Collateral  loans  to  member  banks  ? 

58.  What  is  the  meaning  of  the  item  on  the  resources  side,  "Gold 
redemption  fvmd  "  ? 

59.  What  is  the  meaning  of  "Uncollected  items  and  other  deductions 
from  gross  deposits  "  ? 

60.  Does  the  large  surplus  fund  of  the  Federal  Reserve  banks  indicate 
that  these  institutions  have  been  profiteering  ? 

61.  What  is  the  meaning  of  the  entry  "Deferred  availability  items" 
on  the  liability  side  ? 

62.  What  is  the  ratio  of  reserves  to  Federal  Reserve  note  and  deposit 
liabilities  combined  on  each  of  the  Federal  Reserve  statements 
given  in  the  text?*  Consult  the  financial  press  and  ascertain 
the  present  reserve  ratio. 

REFERENCES  FOR  FURTHER  STUDY 

Agger,  Eugene  E.:  Organized  Banking,  chaps,  xiii  and  siv. 

Dimbar,  Charles  F.:  Chapters  in  the  History  and  Theory  of 
Banking,  third  edition,  revised  and  enlarged  by  O.  M.  W.  Sprague, 
chap.  xii. 

Holdsworth,  John  Thorn:  Money  and  Banking,  chap.  xxii. 

Kemmerer,  Edwin  W.:  The  A.B.C.  of  the  Federal  Reserve  Act. 

Laughlin,  J.  Laurence:  Banking  Progress,  chaps,  iv,  vii,  and  x. 

Moulton,  Harold  G. :  Principles  of  Money  and  Banking,  Part  II, 
chap.  vii. 

Phillips,  Chester  A. :  Readings  in  Money  and  Banking,  chap.  xxxi. 

Willis,  H.  Parker:  The  Federal  Reserve. 

:  American  Banking,  chaps,  xvi-xix. 


CHAPTER  XXVI 

THE  WAR  AND  THE  FEDERAL  RESERVE 

SYSTEM 

Waxs  have  always  been  disruptive  of  financial  systems,  and 
none  more  so  than  the  Great  War  which  began  in  19 14.  The 
Napoleonic  struggle  a  hundred  years  earlier,  for  example, 
reduced  European  currency  systems  to  chaos,  and  a  generation 
of  cmrency  agitation  and  discussion  followed;  while  the 
financial  exigencies  of  our  Civil  War  led  to  the  issue  of  irre- 
deemable paper  money  and  the  abandonment  of  specie  payments 
for  a  period  of  seventeen  years.  But  after  the  gold  standard 
was  definitely  established  by  the  leading  countries  of  the 
world  and  nearly  two  generations  had  elapsed  since  any  great 
western  commercial  nation  had  been  subjected  to  the  disrupting 
influence  of  a  great  war,  it  was  commonly  felt  that  society  had 
learned  important  financial  lessons  and  that  the  requirements 
of  war  would  henceforth  be  met  with  much  less  serious  dis- 
location of  the  financial  and  business  fabric  than  had  been  the 
case  in  the  past.  The  present  condition  of  the  financial  systems 
of  the  world,  however,  unfortunately  affords  conclusive  evidence 
of  the  error  of  this  conviction. 

It  may  be  recalled  that  the  war  in  Europe  commenced  just 
prior  to  the  inauguration  of  our  Federal  Reserve  System. 
After  the  temporary  financial  shock  incident  to  the  outbreak 
of  hostilities  was  passed,  the  first  noteworthy  financial  effect 
upon  the  United  States  of  the  struggle  in  Europe  was  mani- 
fested in  the  shipment  to  this  country  of  great  quantities  of 
gold  in  payment  for  war  supplies,  as  already  indicated  in  the 
chart  on  page  271  above.  These  funds  went,  immediately 
speaking,  into  the  reserves  of  American  banking  institutions. 
This  augmentation  of  specie  holdings,  together  with  the  decrease 
in  reserve  requirements  for  member  banks  that  the  Federal 

624 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM     625 

Reserve  Act  provided,  resulted  in  a  very  great  increase  in  the 
lending  power  of  the  individual  banks. 

Meanwhile  the  volume  of  reserve  money  in  the  Federal 
Reserve  banks  was  also  very  large.  It  will  be  recalled  that 
the  cash  resources  of  the  Federal  Reserve  institutions  were 
originally  derived  in  part  from  the  capital  contributions  of 
the  stock -holding  member  banks  and  in  part  from  deposits, 
both  of  member  banks  and  of  the  federal  government.  These 
sources  yielded  large  funds  to  the  Federal  Reserve  banks  at 
the  very  commencement  of  their  operations.  Later,  the 
amendment  to  the  Federal  Reserve  law  which  made  it  neces- 
sary for  each  member  bank  to  keep  all,  rather  than  merely  a 
portion,  of  its  required  reserve  in  the  Federal  Reserve  bank  of 
its  district,  the  concentration  of  gold  reserves  through  exchan- 
ging Federal  Reserves  notes  for  gold,  as  described  above,  and 
finally,  the  accession  of  the  larger  state  banks  as  members  of 
the  Federal  Reserve  System,  very  greatly  increased  the  volume 
of  reserve  money  in  the  central  reservoirs.  In  1916  the  ratio 
of  cash  to  notes  and  deposits  combined  in  the  twelve  Federal 
Reserve  banks  was  about  87  per  cent;  and  although  for  more 
than  a  year  we  had  one  foot  in  the  conflict,  the  net  reserve  was 
about  77  per  cent  at  the  time  we  formally  entered  the  war  in 
191 7.  Our  financial  structure  was,  therefore,  in  an  extraor- 
dinarily strong  position  for  meeting  the  financial  strain  of  a 
great  war. 

As  everyone  is  aware,  the  period  from  1914  to  1920  has 
been  marked  by  a  revolution  in  prices.  The  chart  on  page  626 
indicates  the  extent  of  the  price  advance  in  each  of  the  lead- 
ing allied  countries.  Russia  and  the  one-time  Central  Powers 
have  witnessed  even  greater  price  changes.  The  causes  of 
this  price  revolution  have  been  variously  assigned  (in  the 
United  States)  to  the  resort  to  borrowing  rather  than  to  taxa- 
tion as  a  means  of  raising  the  funds  required  by  the  govern- 
ment, to  the  loose  extension  of  credit  in  the  form  of  bank  loans, 
to  the  activities  of  labor  unions  in  forcing  wages  to  higher 
levels,  to  the  thriftlessness  and  extravagance  of  people  gener- 
ally, to  the  law  of  demand  and  supply,  to  changed  costs  of 


626 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


production,  to  the  Democratic  party,  etc.  To  attempt  an 
adequate  discussion  of  the  moot  question  of  the  causes  that 
produced  the  price  revolution  would  require  a  volume  in  itself. 


WORLD-MOVEMENT  OF  PRICES, 

1914-20' 

A 

'\ 

A. 

■ 

r 

If' 

ft 
it 

500 

r 

i 

400 

/ 

V 

fl 

/i 

/ 

\ 

Ji 

/ 

\ 

a/J 

/ 

A 

P/ 

¥ 

/ 

•> 

f 

f 

LnTtt 

I     jf    A 

/ 

/ 

.<.%9.' 

w 

/ 

y 

'^h 

(^ 

/.. 

<••• 

^ 

r^^ 

^y^ 

li^ 

i^^  -y 

I9I7 


I9I8 


I9I9 


1920 


1914        I9I5         I9I6 

'Wholesale  prices  in  five  leading  countries.  Prices  for  1913  taken  as 
a  base  of  100.  Taken  from  Report  on  Business  Conditions  (Second  Federal 
Reserve  District),  August,  1920, 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM      627 

And  since  the  price  problem  is  distinctly  a  controversial  one, 
lying  rather  in  the  field  of  advanced  study  than  in  a  general 
introductory  course  in  financial  organization,  no  attempt  will 
be  made  at  this  place  to  discuss  the  causes  of  these  price  changes. 
It  is  in  point  here,  however,  to  note  the  effects  of  the  price 
revolution  that  has  occurred  upon  the  condition  of  our  banking 
system  and  hence  upon  the  problems  of  industrial  and  financial 
reorganization  during  the  post-war  period. 

I.    EFFECT  OF  WAR  FINANCE  UPON  BANK 
RESERVES 

As  the  volmne  of  business  expanded  in  the  United  States 
between  the  years  1915  and  1918,'  the  volume  of  bank  loans  and 
deposit  currency  also  necessarily  expanded.  And  as  the  price 
level  rose  (whether  the  rise  was  caused  by  the  expansion  of 
bank  loans  or  not  is  for  the  present  purpose  immateiial),  the 
volume  of  funds  required  in  the  financing  of  a  given  volume  of 
business  was  also  increased.  Concretely,  by  1918,  when  the 
price  level  was  substantially  double  what  it  had  been  in  19 14, 
there  was  required  to  conduct  a  given  amount  of  business 
about  $2  to  every  $1  that  had  been  required  before  the  war. 
That  is  to  say,  every  business  man  found  that  he  must  have 
substantially  twice  the  amount  of  money  with  which  to  meet 
pay-roll  requirements,  buy  raw  materials,  etc.,  that  had  there- 
tofore been  necessary.  As  we  have  elsewhere  seen,  such 
additional  working  capital  must  characteristically  be  borrowed 
from  the  commercial  banking  institutions. 

The  first  stage  in  the  process  of  expanding  bank  loans  for 
war  purposes — in  1915-16 — resulted  merely  in  drawing  down 
the  excess  reserves  of  member  banks  that  had  been  accumu- 
lated by  the  reduction  of  reserve  requirements  for  member 
institutions  and  by  the  inflow  of  specie  from  Europe.  The 
second  stage,  after  the  excess  reserves  of  member  banks  were 
exhausted,  was  marked  by  heavy  borrowing  on  the  part  of  the 

'The  great  expansion  in  the  volume  of  business  of  course  mainly 
occurred  before  19 18;  since  then  the  physical  volume  of  production  has 
increased  but  slightly,  if  at  all. 


628         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

member  banks  from  the  Federal  Reserve  institutions.  And 
whenever  a  Federal  Reserve  bank  extended  accommodation  to 
member  banks,  either  in  the  form  of  Federal  Reserve  notes  or 
deposit  liabilities,  there  was,  of  course,  a  resultant  reduction 
in  the  ratio  of  its  cash  resources  to  Federal  Reserve  note  and 
deposit  liabilities.  It  should  be  kept  in  mind  in  this  connection 
that  this  process  did  not  occasion  a  withdrawal  of  cash  from 
the  Federal  Reserve  institutions;  on  the  contrary,  the  cash 
resources  were  steadily  increasing  during  the  war  period, 
owing  to  the  poUcy  of  mobilizing  the  gold  resources,  previously 
explained.  The  significant  fact  is  that  the  liabilities  in  the 
form  of  Federal  Reserve  notes  and  deposits  increased  much 
more  rapidly  than  the  cash,  with  the  result  that  the  reserve 
ratio  necessarily  fell. 

Government  financing  also  reduced  bank  reserves.  It  was  not 
only  the  increasing  demands  for  loans  from  business  borrowers 
that  served  to  reduce  the  reserve  ratio;  for  the  government  also 
borrowed  heavily  from  the  commercial  banking  institutions  in 
connection  with  the  flotation  of  the  numerous  war  loans.  The 
truth  is  that  a  very  considerable  percentage  of  the  funds  raised 
for  war  uses  did  not  come  from  individual  savings,  but  were 
created  by  the  banking  institutions  through  a  process  of  ex- 
panding the  ratio  of  deposits  to  cash  resources.  A  concrete 
illustration  will  serve  to  indicate  how,  at  the  twelfth  hour, 
the  Liberty  Loan  drives  always  carried  us  over  the  top. 

Let  us  assume  that  the  X  National  Bank  of  St.  Louis  had  in 
its  portfolio  at  the  time  the  first  Liberty  Loan  was  being  floated 
one  himdred  thousand  dollars  of  commercial  paper  available 
for  rediscount.  On  the  last  day  of  the  campaign  this  bank 
rediscounts  its  one  hundred  thousand  of  commercial  paper 
with  the  Federal  Reserve  bank  of  St.  Louis,  receiving  in  return 
a  deposit  account  at  the  Federal  Reserve  bank  of  one  hundred 
thousand  dollars,  less,  of  course,  the  amount  of  the  discount. 
Now  since  this  deposit  account  constitutes  an  increase  in  the 
lawful  reserve  of  bank  X,  the  bank  is  in  a  position  to  extend 
greatly  the  volume  of  its  business.  Concretely,  it  is  able  to 
invest  a  little  over  seven  hundred  thousand  dollars  in  Liberty 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM      629 

bonds,  paying  for  them  through  the  creation  of  deposit  credits 
in  the  name  of  the  United  States  government.*  (It  will  be 
recognized  that  the  drawing  of  checks  against  government 
deposit  accounts,  as  against  the  accounts  of  individuals,  seldom 
leads  to  withdrawal  of  active  specie.)  By  the  simple  process 
of  rediscounting  the  commercial  notes  of  customers  with  the 
Federal  Reserve  bank,  the  X  National  Bank  has  thus  been 
enabled  to  purchase  more  than  seven  hundred  thousand  dollars' 
worth  of  government  bonds,  the  wherewithal  being  simply 
manufactured  for  the  purpose. 

At  the  time  of  the  second  Liberty  Loan  the  X  National 
Bank  is  again  besought  to  help  save  the  city  from  the  financial 
disgrace  that  would  attend  if  St.  Louis  failed  to  subscribe  for 
"more  than  its  quota"  of  bonds.  By  an  amendment  of  the 
Federal  Reserve  Act,  it  is  possible  for  the  X  National  Bank  to 
borrow  from  the  Federal  Reserve  bank  on  the  collateral  secur- 
ity of  the  first  Liberty  Loan  bonds.  Accordingly,  the  seven 
hundred  thousand  dollars  of  first  Liberty  bonds  in  its  possession 
are  turned  over  to  the  Federal  Reserve  bank  of  St.  Louis 
as  security  for  a  loan  of  seven  hundred  thousand  dollars.  And 
on  the  basis  of  the  new  seven  hundred  thousand  dollar  deposit 
account  thus  received,  the  bank  is  in  a  position  to  buy,  roughly, 
$4,900,000  worth  of  second  Liberty  bonds.  And  since  this 
is  a  game  that  all  of  the  banks  are  enabled  to  play,  the  patriotism 
of  St.  Louis,  and  of  the  nation  at  large,  is  demonstrated  in  most 
convincing  fashion. 

This  process  can  of  course  be  repeated  with  each  successive 
Liberty  Loan,  the  only  limit  to  it  being  the  adequacy  of  the 
reserves  in  the  Federal  Reserve  institutions.  And  since  we 
started  the  war  with  very  large  reserves,  the  process  could, 
in  fact,  be  continued  for  a  year  or  two  without  seriously  strain- 
ing the  reserve  position  of  the  Federal  Reserve  banks.  Anyone, 
therefore,  who  understood  the  mechanism  by  means  of  which 
the  loan  campaigns  were,  at  the  last  moment,  carried  to  trium- 
phant conclusion,  and  who  at  the  same  time  knew  how  large 

»In  accordance  with  the  requirement  that  banks  in  central  reserve 
citieS  must  have  a  reserve  of  13  per  cent. 


630         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

was  the  volume  of  unused  reserves  in  the  Federal  Reserve 
institutions  never  had  any  fear  as  to  the  nation's  ability  to 
raise  practically  any  sum  of  money  the  Treasury  board  of 
strategy  might  decide  upon.  The  fear  rather  was  that  by 
virtue  of  this  simple  process  of  manufacture  the  government 
would  raise  more  funds  than  were  necessary  for  its  financial 
requirements,  with  resulting  evils  in  the  form  of  extravagance 
and  rising  prices,  and  particularly  that  the  ease  with  which  the 
funds  could  thus  be  raised  would  work  as  a  deterrent  to  that 
rigid  economizing  on  the  part  of  all  classes  which  was  absolutely 
hecessary  if  the  productive  machinery  of  the  nation  were  to  be 
successfully  shifted  from  the  production  of  nonessential  and 
relatively  unimportant  commodities  to  the  production  of  the 
indispensable  materials  of  warfare. 

It  may  be  added  that  to  a  considerable  extent,  particularly 
in  the  later  Liberty  Loan  campaigns,  the  Liberty  bonds  that 
were  purchased  on  borrowed  funds  were  not  purchased  by  the 
banks  directly  but  by  individuals  who  borrowed  the  funds 
from  the  banks,  on  the  security  of  previous  Liberty  bonds  as 
collateral.  But  since  the  banks  secured  the  funds  necessary 
for  these  loans  by  borrowing  from  the  Federal  Reserve  banks, 
as  before,  the  immediate  effect  upon  the  reserve  situation  was 
the  same.  The  immediate  effect — but  possibly  not  the  ultimate 
effect — for  the  reason  that  a  campaign  was  at  the  same  time 
inaugurated  to  induce  the  individuals  who  had  borrowed  from 
the  banks  shortly  to  pay  off  their  loans  out  of  future  savings. 
In  view  of  the  insistent  pressure  for  additional  funds,  however, 
it  is  doubtful  whether  any  very  large  volume  of  such  loans 
could,  in  practice,  escape  an  indefinite  number  of  renewals. 

In  any  event,  this  combination  of  demand  for  bank  loans, 
from  the  government  and  from  the  business  community, 
resulted  in  drawing  down  the  reserves  of  the  central  depositaries 
to  about  62  per  cent  at  the  end  of  the  year  1917;  while  by  the 
time  of  the  Armistice  the  figures  stood  at  a  little  over  50  per 
cent.  It  is  altogether  probable,  moreover,  that  if  the  war  had 
continued  for  another  twelve  months  the  reserves  would  have 
been  drawn  down  well  below  the  legal  minima  prescribed  by 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM      631 

the  Federal  Reserve  Act — ^in  which  event  we  should  undoubtedly 
have  had  to  suspend  specie  payments  and  enter  upon  an  era  of 
depreciated  paper.  Indeed,  for  all  practical  purposes,  specie 
payments  were,  in  fact,  already  suspended,  for  the  banks  and 
the  Treasury  Department  alike  practically  refused  "on  grounds 
of  patriotism"  to  pay  out  any  gold.  So  far  as  the  author 
knows,  however,  there  was  never  any  actual  premium  on  gold 
as  compared  with  paper  currency. 

A  similar,  though  much  more  rapid,  reduction  of  reserves  had 
been  occurring  in  Europe.  Indeed,  the  strain  upon  the  financial 
resources  of  the  European  banking  systems  proved  so  great 
at  the  outbreak  of  the  war  that  specie  payments  were  shortly 
abandoned.  The  European  central  banks,  like  our  Federal 
Reserve  institutions,  began  the  war  with  very  large  reserves 
and,  as  was  the  case  in  this  country,  these  reserves  were  added 
to  by  a  policy  of  mobilizing  specie  resources  in  the  central 
reservoirs  where  they  could  be  used  most  efifectively  in  meeting 
the  onerous  financial  requirements  of  the  war.  Thus  notwith- 
standing the  great  outflow  of  gold  from  Europe  to  the  United 
States,  the  central  banks  of  the  belligerent  countries  gradually 
increased  the  aggregate  of  their  specie  resources.  The  financial 
demands  of  the  war  proved  so  great,  however,  and  the  borrowing 
from  the  central  reservoir  institutions  so  continuous,  that  the 
ratio  of  cash  resources  to  liabilities  was  rapidly  reduced.  In 
the  main,  the  resources  of  the  European  central  institutions 
were  substantially  lower  at  the  beginning  of  the  war  than  those 
of  our  Federal  Reserve  banks,  and  as  the  financial  strain  was 
both  greater  and  longer  continued  in  Europe  than  in  the  United 
States,  the  decline  in  specie  reserves  was  very  much  greater 
there  than  here. 

In  all  these  European  countries  the  result  of  this  great 
expansion  of  the  superstructure  of  credit  incident  to  meeting 
the  financial  requirements  of  the  war  resulted,  moreover,  in 
a  gradual  depreciation  of  European  paper  currency.  The 
standard  of  values  ceased  to  be  gold,  contracts  were  made  in 
terms  of  paper  currency,  and  gold  was  quoted  at  a  substantial 
premiiun  in  the  money  markets. 


632         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

II.    THE  MOVEMENT  OF  RESERVES  AFTER 
THE  WAR 

Following  the  Armistice  it  was  widely  believed  for  a  time 
that  there  would  shortly  be  a  gradual  reduction  in  the  financial 
needs  of  governments  and  also  in  the  level  of  prices,  with  the 
result  that  the  volume  of  funds  required  both  by  governments 
and  by  business  men  with  which  to  meet  pay-roll  requirements, 
buy  raw  materials,  etc.,  would  be  gradually  reduced.  In  such 
an  event  the  loans  extended  by  individual  banks  would  be 
decreased  in  volume,  and,  in  turn,  the  amount  of  bank  borrow- 
ing from  the  central  reserve  institutions  would  be  lessened — 
with  the  final  much-desired  result  that  the  reserves  of  the 
Federal  Reserve  banks  would  be  increased.  Such  a  con- 
summation would  have  made  possible  a  gradual  resumption 
of  specie  payments  in  Europe  and  an  ultimate  return  to  a  con- 
servative financial  position.  In  the  United  States  it  would 
have  insured  an  early  restoration  of  the  reserves  of  the  Federal 
Reserve  banks  to  something  like  the  pre-war  level  and  in 
consequence  a  financial  system  strongly  entrenched  to  meet 
the  requirements  of  future  business  cycles. 

But  as  the  result  of  factors  which  need  not  here  be  con- 
sidered, prices  did  not  decline  for  long  after  the  Armistice,  but 
rose  instead  with  the  inauguration  in  April,  1919,  of  an  upward 
swing  of  a  new  business  cycle.  The  process  by  which  increasing 
pressure  had  been  brought  to  bear  by  business  borrowers  upon 
the  member  banks  and  through  them  upon  the  Federal  Reserve 
institutions  for  funds  during  the  war  was  thus  resumed,  with 
the  inevitable  result  of  a  still  further  decline  in  the  reserves  of 
the  Federal  Reserve  institutions.' 

The  sources  of  the  increased  demand  for  futids  were  numerous. 
It  should  be  observed  in  this  connection  that,  as  is  always  the 
case  in  a  period  of  very  active  business,  the  pressure  upon 
the  commercial  banks  for  loans  did  not  come  merely  from  the 
manufacturing  and  mercantile  interests;  it  came  to  a  very  con- 

'  Government  financing  also  continued  as  a  carry-over  from  the  war, 
though  henceforth  it  was  of  a  declining,  rather  than  a  steadily  augmenting, 
volume. 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM     633 

siderable  extent  from  stock  exchange  speculation,  and  from  the 
flotation  of  new  issues  of  corporate  securities.  It  will  be 
recalled  from  our  previous  analysis  of  the  relation  of  the  com- 
inercial  banking  system  to  the  financing  of  stock  exchange 
speculation,  to  the  outright  purchase  of  securities,  to  the  making 
of  collateral  loans  for  fixed  capital  purposes,  and  to  the  activities 
of  investment  bankers  engaged  in  the  marketing  of  securities, 
that  the  funds  of  the  commercial  banking  system  constitute 
the  support  for  the  entire  financial  fabric,  investment  and 
speculative,  as  well  as  commercial.  The  great  stock  speculation 
of  the  year  1919  absorbed  large  quantities  of  bank  funds,  while 
the  flotation  of  securities  which  were  either  carried  by  invest- 
ment bankers  or  by  individuals  on  funds  borrowed  on  collateral 
served  still  further  to  reduce  the  reserves  of  the  Federal  Reserve 
banks.  An  important  factor,  also,  was  the  organization  of  a 
horde  of  financing  or  stock  jobbing  concerns  engaged  in  the 
promotion  of  speculative  enterprises,^  all  of  which  absorbed 
funds;  while  the  land  booms  in  many  states  still  further  added 
to  the  financial  strain.  Both  speculation  and  investment, 
save  in  government  securities,  had  been  largely  held  in  abeyance 
during  the  war  period  by  restrictive  legislation  and  by  the 
activities  of  the  Capital  Issues  Committee,  which  effectively 
prevented  in  the  latter  part  of  the  war  the  sale  of  securities  of 
concerns  that  were  not  deemed  essential  to  the  winning  of  the 
struggle.  Hence  when  the  post-war  boom  period  developed, 
an  extraordinary  volume  of  new  issues  was  floated. 

Another  factor  in  the  rapid  depletion  of  our  reserves  after 
the  Armistice  was  the  outflow  of  specie  from  the  United  States 
to  South  America  and  the  Orient  in  the  meeting  of  adverse 
trade  balances.  This  amounted,  between  Jvme  i,  1919,  and 
January  i,  1920,  to  approximately  $300,000,000.  It  should  be 
recalled  in  this  connection  that  since  in  our  financial  system 
the  cash  reserves  need  be  only  about  5  per  cent  of  the  total 
outstanding  claims  against  cash,  every  dollar  of  specie  that  is 
exported  means  a  curtailment  of  credit,  or  of  credit  possibilities, 
to  the  extent  of  about  twenty   dollars.     The  trade  balance 

*  See  pp.  191-92. 


634         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

with  Europe  during  this  interval  was  heavily  in  our  favor  and 
under  normal  circumstances  we  should  have  had,  in  consequence, 
a  large  inflow  of  specie;  but  because  of  the  strained  condition 
of  European  bank  reserves,  it  was  deemed  necessary  to  continuie 
the  embargoes  upon  gold  shipments.'  Accordingly,  the  United 
States  was  placed  in  a  position  of  holding  the  financial  fort 
for  pretty  much  the  entire  world. 

The  result  of  these  various  strains  upon  the  financial  system 
was  shortly  to  reduce  the  reserve  ratios  in  the  Federal  Reserve 
banks  from  above  50  per  cent  to  a  point  dangerously  near  the 
minimum  reserve  requirements  laid  down  under  the  Federal 
Reserve  Act.  By  the  end  of  the  year  1919  the  ratio  of  cash 
to  Federal  Reserve  note  and  deposit  liabilities  combined  in 
the  twelve  Federal  Reserve  banks  was  below  45  per  cent. 
The  question  whether  the  Federal  Reserve  System  might  fail 
to  control  the  expansion  of  credit  and  to  prevent  the  recurrence 
of  financial  panics  such  as  occurred  in  the  old  days  of  unorgan- 
ized banking  therefore  became  of  more  than  academic  interest. 
It  was  frankly  feared  by  many  that  if  the  central  reserves 
should  continue  to  fall  until  they  reached  the  legal  minima, 
we  should  not  be  in  a  very  much  better  position  to  meet  the 
conditions  of  an  acute  crisis  than  was  the  case  lender  the  old 
banking  system.' 

Ill,    THE  ATTEMPT  TO  CONTROL  CREDIT  AND 
BUSINESS  EXPANSION 

The  advance  in  prices  following  the  Armistice  began  at  a 
time  when  government  financial  requirements  were  still  at 
their  height.  The  Victory  Loan  had  yet  to  be  floated  and  a 
large  volume  of  borrowing  through  the  issue  of  Treasury 
certificates  of  indebtedness  was  still  necessary.  The  Treasury 
Department  was  desirous  of  placing  these  loans  at  as  low  an 
interest  rate  as  possible,  and  accordingly  the  Federal  Reserve 
Board  made  no  early  effort  to  check  the  expansion  of  credit 
and  of  business  activity  by  means  of  its  control  over  discount 

'  Cf.  pp.  270-71.  »  But  see  below,  p.  643. 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM     635 

rates.  The  Board  has  been  criticized  by  some  for  its  policy 
in  this  connection.  In  justification  it  may  at  least  be  said 
that  until  the  early  autumn  of  19 19  it  was  not  apparent  how 
severe  the  financial  strain  was  to  be.  Certainly  at  the  time 
the  details  of  the  Victory  Loan  financing  were  arranged  there 
was  no  consensus  of  opinion  that  the  price  level  was  going  to 
advance  and  that  we  were  to  enter  upon  a  stage  of  very  active 
business.  Moreover,  it  was  highly  important  that  every  effort 
be  made  to  promote  a  revival  of  business  activity  in  order  to 
facilitate  the  absorption  of  the  returning  war  workers  and 
soldiers  and  the  early  rehabilitation  of  the  depleted  economic 
resources  of  the  world;  and  a  sharp  rise  in  discount  rates 
would  probably  have  been  a  deterrent  to  such  economic  recovery. 
In  any  event,  once  committed  to  a  policy  of  low  interest  rates, 
it  was  impossible  for  the  Federal  Reserve  Board  to  raise  rates 
during  the  period  of  the  Victory  Loan  financing  without  break- 
ing faith  with  the  bankers  of  the  country,  who  had  formulated 
policies  and  made  loans  on  the  understanding  that  the  Victory 
Loan  was  to  be  put  through  at  a  low  interest  rate. 

There  are  many  who  believe,  however,  that  the  Federal 
Reserve  Board  waited  longer  than  was  necessary  before  inaugu- 
rating a  policy  of  higher  interest  rates  and  endeavoring  to 
conserve  our  financial  resources  for  more  essential  requirements. 
In  the  early  summer  of  19 19  an  official  warning  was,  indeed, 
issued,  urging  the  necessity  of  curtailing  loans  for  speculative 
purposes  in  the  interests  of  "legitimate"  commercial  needs; 
but  it  passed  virtually  unheeded  either  by  the  banks  or  by  the 
speculative  community.  The  warning  was  not  reiterated 
until  the  middle  of  October;  by  this  time  the  credit  situation 
had  become  very  grave,  following  an  extraordinary  period  of 
unrestrained  speculation.  On  this  occasion  the  banks  of 
New  York  co-operated  with  the  Federal  Reserve  Board,  sharply 
raising  rates  on  call  money  and  actually  restricting  the  volume 
of  credit  that  brokers  might  obtain,  with  a  resulting  abrupt 
collapse  of  stock  market  values  and  the  permanent  dissolution 
of  the  bull  market  that  had  prevailed — with  an  August  inter- 
mission— since  the  early  spring. 


636         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

A  curtailment  of  stock  exchange  speculation  did  not, 
however,  suffice,  and  could  not  in  the  nature  of  things  suffice, 
to  relieve  the  monetary  strain.  What  was  needed  was  a 
thoroughgoing  readjustment  of  prices  to  a  lower  basis — defla- 
tion, to  use  a  common  expression — even  though  it  be  accom- 
panied by  a  halting  of  business  activity.  Not  until  January, 
1920,  apparently,  did  the  Federal  Reserve  Board  fully  appre- 
ciate the  gra\dty  of  the  reserve  situation  and  seek  to  effect  a 
readjustment  of  conditions.  After  a  conference  with  leading 
bankers  it  was  then  decided  that  the  necessities  of  the  credit 
situation  demanded  a  real  advance  in  discount  rates.'  The 
increase  was  not  very  great,  however,  for  a  cautious  f eeUng  of  the 
way  seemed  advisable;  and,  moreover,  it  was  still  the  belief 
of  many  that  an  elimination  of  loans  for  speculative  purposes — 
commodity  speculation  as  well  as  stock  exchange  speculation — 
would  release  a  sufficient  quantity  of  funds  to  take  care  of 
essential  business  requirements  without  necessitating  any 
drastic  readjustment  of  business.  It  was  hoped  that  a  moderate 
increase  of  discount  rates,  together  with  a  sharp  discrimination 
by  bankers  against  speculative  loans,  would  accomplish  the 
desired  results. 

During  the  early  months  of  1920,  however,  the  advance  in 
interest  rates  appeared  to  have  little  effect  upon  business 
activity.  The  profits  that  might  be  derived,  in  most  lines  of 
industry,  from  the  use  of  borrowed  funds  were  so  great  that 
interest  rates  were  for  the  time  a  matter  of  only  secondary 
importance.  The  volume  of  loans  therefore  continued  to 
be  large,  business  continued  to  be  active,  and  prices  continued 
to  rise;  and  until  March  there  was  little  surface  indication 
that  price  and  business  readjustments  were  in  store. 

Despite  subsequent  further  increases  in  the  discount  rates 
at  the  Federal  Reserve  banks,  and,  in  consequence,  almost 
immediately  at  the  member  institutions,  the  credit  strain 
became  increasingly  acute  until  late  in  May,  when  the  Federal 
Reserve  Board  again  called  a  conference  of  bankers  to  consider 
how  the  volume  of  loans  might  be  reduced  and  the  reserves 

'  Very  slight  advances  had  been  made  in  November  and  December. 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM      637 

replenished  sufficiently  to  accommodate  the  autumn  seasonal 
requirements  without  danger  of  a  financial  collapse.  It  was 
agreed  at  this  conference  that  before  autumn  it  wovdd  be 
necessary  to  curtail  loans  on  the  average  by  about  10  per  cent, 
if  the  banks  were  to  be  placed  in  a  position  to  meet,  without 
serious  difficulty,  the  demands  that  were  certain  to  be  placed 
upon  them  during  the  crop-moving  period.  Before  considering 
the  subsequent  events,  however,  it  will  be  well  to  refer  briefly 
to  certain  changes  in  economic  conditions  that  had  already 
occurred  during  the  spring. 

Other  economic  factors  helped  to  bring  about  a  readjustment  of 
business  and  financial  conditions.  Aside  from  the  great  increase 
in  interest  rates,  at  least  two  other  factors  of  major  importance 
were  conspiring  to  bring  about  a  readjustment  of  business  and 
prices  in  the  spring  of  1920.  First,  there  was  the  break-down 
of  the  transportation  system,  owing  to  a  combination  of  factors 
which  need  not  be  considered  here.  The  result  of  this  break- 
down manifested  itself  in  two  ways.  In  the  first  place,  the 
inability  of  the  railroads  to  move  commodities  at  the  ordinary 
rate  slowed  up  the  entire  productive  and  distributive  process 
and  made  it  necessary  for  business  men  everywhere  to  secure 
extensions  of  credit  for  a  longer  period  and  for  larger  amounts 
than  would  otherwise  have  been  required.  A  new  expression, 
''frozen  credit,"  was  coined  to  describe  this  condition.  The 
result  of  this  inability  of  traffic  to  move  was  thus  to  augment 
the  pressure  on  the  banks  for  loans  and  thereby  to  reduce 
still  further  the  ratio  of  cash  to  deposit  and  note  liabilities. 
And  notwithstanding  the  fact  that  there  was  a  considerable 
(unexpected)  inflow  of  gold  to  the  United  States  in  April, 
incident  to  the  pre-payment  of  the  British  share  of  the  Anglo- 
French  loan,  maturing  in  October,  the  reserves  of  the  twelve 
Federal  Reserve  banks,  combined,  continued  to  decline  until 
in  May  they  reached  the  low  level  of  about  42.5  per  cent. 
A  further  factor  which  contributed  to  the  financial  uncertaint\- 
of  these  months  was  the  settlement  of  the  tremendous  volume 
of  farm  real  estate  transfers  that  had  been  contracted  in  the 
boom  period  of  the  preceding  year. 


638  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  second  result  of  the  transportation  tie-up  was  a  slowing 
down  of  business  activity.  The  inability  to  secure  coal  and 
raw  materials  and  to  ship  the  finished  products  with  any  degree 
of  certainty  proved  to  be  a  very  depressing  element,  discoura- 
ging further  business  commitments  and  substantially  reducing 
the  industrial  output  of  the  country. 

The  other  major  factor  that  was  contributing  to  a  readjust- 
ment of  business  conditions  was  the  high  cost  of  living.  The 
steady  rise  in  commodity  prices  during  1919  and  the  first  months 
of  1920,  accompanied  as  it  now  was  by  substantial  increases  in 
rents,  had  finally  reached  a  point  where  it  was  forcing  a  curtail- 
ment of  consumptive  demand.  Whatever  may  have  been  the 
case  earlier,  it  had  by  this  time  certainly  become  true  that 
the  net  annual  wages  of  labor,  speaking  generally,  as  well  as  the 
income  of  the  salaried  classes,  were  failing  to  keep  pace  with 
advancing  prices,  with  a  resulting  decline  in  the  real  purchasing 
power  of  the  rank  and  file  of  people.  The  "peak"  of  prices 
was  reached  in  the  spring  of  1920,  among  other  reasons,  because 
consumptive  demand  was  not  sufficient  to  absorb  the  existing 
volume  of  production  at  the  prices  for  which  goods  were  then 
being  offered.  Popular  hostility  to  the  continuous  marking 
up  of  prices  is  also  believed  by  many  to  have  finally  led  to  a 
voluntary  reduction  of  purchases.  In  any  event  the  result  of 
the  curtailed  consumptive  demand  was  manifested  in  the 
month  of  May  in  retail  price  concessions  in  silks,  textiles, 
leather  goods,  and  a  few  other  commodities. 

Another  factor  which  no  doubt  contributed  somewhat 
to  the  unsettling  of  American  business  was  the  decline  in  our 
trade  balance,  which  became  pronounced  in  the  spring  of  1920. 
The  decrease  in  foreign  demand  and  the  increasing  competition 
of  imported  commodities  were  alike  influences  tending  to 
bring  about  business  readjustment  in  the  United  States. 

Pertinence  is  given  to  the  suggestion  that  numerous  factors 
besides  the  rising  interest  rates  contributed  much  to  the  price 
and  business  readjustment  which  we  have  been  discussing,  by 
virtue  of  the  fact  that  the  readjustment  is  a  world-wide  phe- 
nomenon and  is  found  in  countries  that  have  not  raised  interest 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM      639 

rates  as  well  as  in  those  that  have.  It  appears  to  have  had  its 
definite  beginning  in  the  financial  crisis  in  the  Orient,  which 
occurred  in  February. 

We  may  now  return  to  a  consideration  of  the  manipulation 
of  the  interest  rate.  What  is  to  be  said  of  the  effectiveness  of 
this  method  of  control  as  tested  in  the  spring  of  1920?  The 
answer,  in  brief,  appears  to  be  that  the  increase  of  interest 
rates  played  a  part  in  superinducing  the  business  reaction  that 
began  in  May,  but  that  it  was  greatly  aided  and  abetted  by  the 
transportation,  cost  of  Uving  and  other  conditions  already 
discussed.  No  one  will  ever  know,  in  fact,  whether,  in  the 
absence  of  these  contributing  factors,  the  raising  of  interest 
rates  would  have  succeeded  in  checking  the  volume  of  business 
and  bringing  about  a  price  readjustment  in  time  to  prevent  a 
financial  panic  of  the  old-fashioned  sort.  The  unresolved 
issue  is,  whether  if  transportation  facilities  had  been  normal, 
and  if  money  wages  could  have  kept  substantial  pace  with 
rising  prices  for  only  a  few  months  longer,  the  rise  in  interest 
rates  would  of  itself  have  sufficiently  narrowed  margins  of 
profit  to  precipitate  a  business  readjustment  and  a  reduction  of 
prices  before  the. reserves  had  been  reduced  to  the  breaking 
point.^ 

In  any  case  it  is  of  interest  to  consider  the  events  subsequent 
to  the  conference  of  bankers  with  the  Federal  Reserve  Board 
mentioned  above.  While  it  was  believed  that  a  substantial 
curtailment  of  loans  was  indispensable  to  the  safety  of  the 
credit  system,  it  was  felt  that  this  curtailment,  in  accordance 
with  American  traditions,  should  not  be  forced  from  above,  but 
should  be  worked  out  by  individual  bankers,  each  deciding  for 
himseK  the  volume  of  loan  curtailment  that  could  reasonably 
be  effected  by  his  institution.  Under  this  method  it  is  very 
doubtful  if,  in  the  absence  of  the  untoward  business  develop- 
ments discussed  above,  an  adequate  volume  of  loan  contraction 
could  have  been  effected.  The  pressure  that  is  brought  to  bear 
upon  each  individual  banker  to  take  care  of  the  financial 

*  See  also  p.  642. 


640         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

requirements  of  "valued  customers"  is,  usually,  too  strong  to 
be  resisted  wholly;  when  it  comes  to  the  point,  it  is  so  much 
easier  to  let  the  others  carry  the  responsibility.  If  business 
had  been  still  straining  at  the  leash,  as  it  was  in  the  autumn  of 
1919,  for  example,  the  best  that  could  have  been  hoped  for 
from  this  method  of  loan  contraction  would  probably  have 
been  the  prevention  of  still  further  expansion  and  a  consequent 
maintenance  of  reserves  at  the  then  existing  level. 

Be  all  this  as  it  may,  the  business  depression  that  began 
in  the  spring  undoubtedly  very  greatly  aided  the  Federal 
Reserve  Board  and  the  bankers  generally  in  their  efforts  to 
avert  a  further  deterioration  in  the  reserve  position.  Mer- 
chants unable  to  dispose  of  their  stocks  at  existing  prices  made 
concessions,  meanwhile  canceling  orders  from  wholesalers 
and  manufacturers  and  even  returning  large  volumes  of  goods 
that  had  already  been  delivered.  This  in  turn  resulted  in  the 
partial  suspension  of  operations  by  many  mills  and  factories 
and  in  the  complete  closing  of  others.  And  as  is  always  the 
case,  the  resulting  increase  in  unemployment  had  its  effect  in 
still  further  reducing  consumptive  demand,  and  thus  in  bringing 
cumulative  pressure  to  bear  upon  prices — the  price  recessions 
gradually  extending  to  nearly  all  groups  of  commodities.  More- 
over, as  is  again  always  the  case  in  every  period  of  depression, 
construction  activities,  that  is,  the  creation  of  additional 
capital  goods,  were  very  sharply  curtailed,  thus  reducing  the 
purchasing  power  of  all  those  engaged  in  the  building  industry, 
as  well  as  the  demand  for  building  materials. 

This  slowing  down  of  business  activity  and  recession  of 
prices,  in  fact,  made  it  incumbent  upon  bankers,  if  they  would 
safeguard  their  own  immediate  financial  position,  to  scrutinize 
the  making  of  loans  with  unusual  care.  For  as  soon  as  margins 
of  profit  began  to  decline,  inventory  values  to  shrink,  and 
business  failures  to  increase,  the  possibility  of  bank  losses  was, 
of  course,  very  greatly  increased.  That  such  sUght  loan  con- 
traction as  ensued  is  by  no  means  wholly  attributable  to  the 
efforts  of  the  bankers  to  fulfil  their  responsibilities  under  the 
informal  agreement  reached  with  the  Federal  Reserve  Board  in 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM      641 

May,  can  be  seen  from  the  following  considerations:  The  policy 
that  had  been  formulated  was  to  restrict  loans  only  for  non- 
essential purposes,  since  it  appeared  to  be  the  height  of  economic 
unwisdom  to  hamper  the  production  of  the  necessities  of  life 
at  a  time  when  the  productive  capacity  of  the  world  as  a  whole 
was  so  sadly  in  arrears;  indeed,  an  increase  in  total  produc- 
tion— concentrated  in  lines  of  basic  importance — was  to  be 
fostered.  But  the  truth  of  the  matter  is  that  the  curtail- 
ment of  loans  that  was  in  fact  effected  through  the  initiative 
of  bankers  was  by  no  means  confined  to  nonessential  lines  of 
activity.  For  example,  one  of  the  first  lines  to  feel  the  effect 
of  loan  contraction  was  the  building  industry,  particularly 
the  housing  division  of  the  industry,  where  the  need  for  increased 
production  was  doubtless  greater  than  anywhere  else.  On  the 
other  hand,  loans  to  many  industries — which  everyone  would 
place  in  at  least  the  "relatively  unimportant"  class — were 
scarcely  restricted  at  all.  The  bankers  can  hardly  be  criticized 
for  this  stand  since  under  the  conditions  that  prevailed  the 
risks  of  loss  and  failure  were  undoubtedly  greater  in  connection 
with  certain  very  essential  lines  of  activity  than  in  many  Knes 
of  relative  unimportance.  And  besides  having  a  responsibility 
to  promote  the  general  welfare,  the  managers  of  banks  have 
quite  as  important  a  responsibility  in  conserving  the  financial 
position  of  the  banks  in  the  interests  of  their  stockholders. 

Loans  for  commodity  speculation  were,  however,  substan- 
tially reduced,  the  banks  being  aided  in  the  process  by  virtue  of 
the  fact  that  price  recessions  were  rapidly  placing  loans  for 
speculative  purposes  in  the  highly  risky  class.  Furthermore, 
as  soon  as  the  price  readjustment  became  general,  such  specula- 
tors were  glad  to  retire  from  the  field.  It  is  probable,  however, 
that  the  volume  of  loan  contraction  that  was  effected  was  much 
less  in  the  aggregate  in  speculative  lines  than  it  was  in  essential 
industries. 

Notwithstanding  the  aid  that  was  given  to  the  Federal 
Reserve  Board  in  its  efforts  to  bring  about  deflation  by  the 
forces  which  we  have  just  been  considering,  there  was  no 
appreciable  improvement  in  the  reserve  situation  during  the 


642  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

summer  and  early  autumn  of  1920 — the  date  of  the  present 
writing.  In  a  sense,  July,  August,  and  September  witnessed  a 
credit  race,  with  the  contestants  running  in  opposite  directions, 
as  it  were.  That  is  to  say,  there  was  a  race  between  the  extent 
to  which  the  volume  of  loans  might  be  reduced  in  industrial' 
and  speculative  lines  and  the  extent  to  which  they  would  have  to 
be  increased  elsewhere,  in  order  to  take  care  of  the  autumn 
seasonal"  demands.  At  the  present  moment  it  appears  that 
reserves  are  not  likely  to  be  carried  below  the  40  per  cent 
limit — that  the  crop-moving  requirements  will  be  taken  care  of 
only  to  the  extent  that  funds  are  released  in  other  directions, 
with  the  reserves  as  a  whole  remaining  slightly  above  the  mini- 
mum requirements.* 

It  is  of  interest  to  observe  in  this  connection  that  a  shortage 
of  credit,  like  a  dearth  of  transport  faciUties,  results  in  extending 
the  movement  of  the  crops  over  a  substantially  longer  period 
of  time.  The  farmers  are,  in  fact,  storing  a  much  larger  portion 
of  their  produce  this  year  than  has  ordinarily  been  the  case. 
It  should  be  noted,  however,  that  the  accompanying  post- 
ponement of  rural  consumptive  demand  is  not  without  an 
important  bearing  upon  the  general  industrial  situation.  In 
any  event,  if  the  industrial  depression  should  become  more 
rather  than  less  severe  in  the  ensuing  months,  as  appears  not 
improbable,  it  will  be  possible  in  the  end  to  move  the  crops  to 
market  without  seriously  straining  the  financial  resources  of 
the  country. 

There  was  a  genuine  business  crisis  in  the  early  summer  of 
ig20.  One  other  fact  remains  to  be  mentioned  in  connection 
with  the  crisis  of  1920.  Beginning  about  the  middle  of  May, 
the  credit  tension  became  of  the  acute  variety  that  has  hereto- 
fore characterized  the  weeks  immediately  preceding  a  financial 
collapse.  Just  as  soon  as  the  decline  in  prices,  with  the  con- 
current slackening  of  industry  and  the  backing  up  of  the 
speculative  waters,  began,  great  nimibers  of  business  men  were 

■  Business  depression  substantially  reduced  the  autumn  credit  require- 
ments of  manufacturers  and  producers  of  materials. 
»  Written  in  early  October,  1920. 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM      643 

panic  stricken  much  as  in  former  times.  The  cancellation 
of  business  orders,  the  failure  of  creditors  to  meet  their  obliga- 
tions promptly,  the  recurring  slumps  in  inventory  values,  and 
the  uncertainty  as  to  the  whole  future  trend  of  events  developed 
a  veritable  business  crisis — accompanied  by  the  usual  insistent 
pressure  upon  the  banks  for  loans  with  which  to  tide  over  the 
interval  of  readjustment.  There  was  one  noteworthy  difference, 
however,  between  this  and  former  similar  occasions.  Wide- 
spread confidence  in  the  Federal  Reserve  System  proved  a 
powerful  sedative. 

It  is  significant  to  note  in  this  connection  that  the  short- 
time  commercial  credit  that  was  outstanding  could  no  more  be 
hquidated  than  any  other  credit  obligations;  the  Federal 
Reserve  System  was  called  upon  to  "carry"  the  entire  credit 
burden.  This  it  proved  able  to  do  by  virtue  of  the  margin  of 
unused  reserves  that  still  existed.  Whether  or  not  the  Federal 
Reserve  System  would  have  been  able  to  prevent  a  financial 
collapse  if  the  period  of  expansion  had  been  continued  until 
the  reserves  were  down  to  the  legal  minima,  it  undoubtedly 
prevented  a  financial  panic  in  late  May  or  early  June 
of  1920. 

Various  Federal  Reserve  devices  for  controlling  credit  have 
been  tested.  It  will  now  be  pertinent  to  consider  briefly  the 
extent  to  which  the  various  devices  for  avoiding  financial 
panics — other  than  the  control  of  the  discount  rate — have  been 
utilized  by  the  Federal  Reserve  System  in  the  recent  crisis. 
It  will  be  observed,  first,  that  rediscounting  of  customers' 
notes  and  direct  borrowing  from  the  Federal  Reserve  banks  by 
member  institutions,  both  state  and  national,  have  been  a 
conspicuous  feature  of  the  credit  strain  since  early  in  the 
war.  There  would  seem  to  be  little  doubt  that  in  the 
absence  of  the  assistance  rendered  to  individual  banks  we 
should  long  ago  have  had  a  serious  financial  collapse.  The 
advantages  of  the  maintenance  of  central  reservoirs  of  lending 
power  as  a  means  of  strengthening  the  weak  links  in  the 
financial  structure  appear  to  have  been  demonstrated  beyond 
any  doubt. 


644  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

It  is  of  note,  second,  that  the  various  Federal  Reserve  banks 
have  rendered  much  assistance  to  each  other  through  inter- 
borrowing  operations,  the  credit  strain  thus  being  disseminated 
throughout  the  entire  banking  system.  This  has  been  a  note- 
worthy feature  of  the  financial  system  ever  since  the  tension 
upon  bank  reserves  became  acute.  It  appears  that  most  of 
the  Federal  Reserve  banks  have  at  one  time  or  another,  during 
the  last  year  or  so,  been  both  borrowers  from  and  lenders  to 
sister-institutions;  and  there  have  been  numerous  occasions 
where  the  shifting  of  funds  from  one  financial  center  to  another 
has  been  of  large  aggregate  volume  in  a  very  short  period  of 
time.  A  high  degree  of  flexibility  has  thus,  in  fact,  been 
obtained  within  the  financial  system  as  a  whole.  In  the 
absence  of  this  mutual  co-operation  of  the  several  Federal 
Reserve  institutions  it  is  entirely  possible  that  certain  reserve 
districts  might  have  suffered  from  actual  financial  collapse, 
and  this  would  doubtless  have  involved  the  entire  system. 

In  the  third  place,  as  already  noted,  it  has  not  been  neces- 
sary, however,  to  cut  below  the  minimum  reserve  requirements, 
under  the  method  provided  by  the  Federal  Reserve  Act.' 
We  have  therefore  no  definite  means  of  knowing  whether  this 
could  be  accomplished  without  serious  alarm  to  the  business 
community.  It  is  possible  that  if  an  announcement  were  made 
that  the  combined  reserves  of  the  Federal  Reserve  banks  were 
below  the  35  and  40  per  cent  minima  and  that  the  Federal 
Reserve  Board  had  suspended  these  requirements  as  an  emer- 
gency measure,  certain  timid  depositors  might  fear  the  worst 
and  resort  to  the  familiar  practice  of  hoarding.  It  is  also 
conceivable  that  individual  banks  might  become  alarmed  and 
withdraw  funds  from  the  financial  centers  for  hoarding  in  their 
own  vaults  and  thereby  seriously  imperil  the  ability  of  the 
Federal  Reserve  institutions  to  weather  the  storm.  If  the 
system,  however,  succeeds  in  passing  through  one  great  financial 

*See  p.  597.  It  is  true,  however,  that  on  more  than  one  occasion 
the  reserves  of  the  New  York  bank  have  been  temporarily  slightly  below 
the  minimum  requirements — a  condition,  however,  which  has  been  quickly 
remedied  by  borrowing  from  other  Federal  Reserve  institutions. 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM      645 

Strain  successfully,  the  confidence  resulting  therefrom  will 
undoubtedly  practically  eliminate  this  danger  for  the  future. 

It  should  be  noted  in  this  connection  that  the  requirement 
of  the  Federal  Reserve  Act,  as  amended,  that  member  banks 
shall  keep  all  of  their  legal  reserves  with  the  Federal  Reserve 
institutions,  has  not  accomplished  one  important  result  that 
was  expected,  namely,  that  of  preventing  the  sending  of  funds 
for  deposit  to  the  banks  of  the  great  financial  centers.  In  fact, 
it  is  doubtful  if  we  have  ever  had  a  greater  concentration  of 
funds  than  has  been  the  case  during  the  boom  period  of  1919. 
These  funds  were  in  part  deposited  with  correspondent  banks 
in  New  York  and  other  financial  centers,  interest  being  paid 
at  2  or  2  .5  per  cent  on  balances;  but  in  larger  measure  than 
ever  before  they  were  loaned  directly  by  western  bankers  to 
speculators  on  the  exchanges.  The  ease  with  which  member 
banks  could  replenish  their  reserves  through  borrowing  from 
the  Federal  Reserve  institutions — as  long  as  reserves  there 
were  ample — appears,  indeed,  definitely  to  have  promoted 
rather  than  retarded  the  accumulation  of  funds  for  stock 
exchange  speculation. 

Another  factor  of  importance — and  of  danger — in  the  present 
crisis  has  been  the  existence  in  New  York  of  a  large  volume  of 
call  loans  contracted  by  Canadian  borrowers.  A  sudden 
withdrawal  of  these  funds  might  well  have  proved  a  serious 
matter  if  it  had  occurred  coincidently  with  other  untoward 
developments. 

Finally,  at  the  present  juncture,  the  raising  of  interest  rates 
in  our  market  could  not  have  the  effect  normally  expected  in 
influencing  the  international  flow  of  specie.  The  disorgani- 
zation of  the  foreign  exchanges,  coupled  with  the  embargo  upon 
European  gold  exports,  has  for  the  present,  at  least,  rendered 
practically  impotent  this  part  of  the  machinery  of  control. 
The  most  that  could  be  accomplished  would  be  to  retard  the 
outflow  of  specie  to  those  countries  with  which  our  trade 
balances  have  recently  been  adverse. 

While  it  is  premature  to  attempt  any  final  statement  of  the 
effectiveness  of  the  machinery  of  credit  control  provided  by 


646         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  Federal  Reserve  System,  as  measured  by  the  financial 
events  of  the  past  six  years,  it  would  appear  that  a  favorable 
verdict  must,  on  the  whole,  be  rendered.  While  serious  mis- 
takes as  to  credit  policy  have  doubtless  been  made,  it  will, 
no  doubt,  be  generally  conceded  that  the  financial  problems  of 
the  world-war  and  its  aftermath  have  been  of  unprecedented 
complexity  and  magnitude  and  that  the  fallible  human  admin- 
istrators of  the  modern  financial  organization  have  done  about 
as  well  as  could  reasonably  have  been  expected.  It  is  at  least 
gratifying  that  the  management  of  the  new  American  financial 
system  has  compared  very  favorably  with  that  of  the  older 
and  more  fully  developed  European  systems. 

QUESTIONS  FOR  DISCUSSION 

1.  State  the  various  means  by  which  the  reserves  of  the  Federal 
Reserve  institutions  were  built  up  between  1914  and  1917. 

2.  Evidence  h^s  been  presented  to  show  that  the  physical  volume 
of  business  increased  between  1914  and  1918  by  about  8  per  cent. 
Assiuning  the  price  level  to  have  remained  the  same,  how  would 
this  have  affected  the  reserves  of  the  Federal  Reserve  institutions  ? 

3.  Show  how  a  doubling  of  the  price  level  would  affect  bank  reserves. 

4.  So  far  as  reserves  were  concerned,  did  it  matter  particularly 
whether  borrowing  from  the  Federal  Reserve  bank  took  the 
form  of  Federal  Reserve  notes  or  deposit  accounts  ? 

5.  What  determined  the  maximum  amount  of  Liberty  bonds  (a)  that 
any  individual  bank  coxild  purchase;  (b)  that  the  banks  as  a 
whole  could  purchase  ? 

6.  What  determined  the  total  volume  of  Liberty  bonds  that  indi- 
viduals could  purchase  through  the  use  of  their  credit  at  the 
banks,  that  is,  on  funds  borrowed  from  the  banks  on  collateral 
security  ? 

7.  Show  concretely  how  the  banks  woidd  ultimately  have  to  give 
up  the  pajonent  of  specie  on  demand. 

8.  Draw  up  in  summary  form  a  statement  of  the  various  sources  of 
credit  absorption  during  the  upward  swing  of  the  business  cycle 
which  began  in  the  spring  of  1919.  Which  do  you  regard  as 
most  important  ? 

9.  Explain  the  large  export  of  specie  in  1919  and  1920.  Explain 
why  for  every  dollar  of  specie  exported  there  must  be  a  credit 
curtailment  of  substantially  twenty  dollars. 


THE  WAR  AND  THE  FEDERAL  RESERVE  SYSTEM      647 

TO.  If  you  had  been  a  member  of  the  Federal  Reserve  Board  in  the 
spring  of  1919,  what  policy  would  you  have  advocated?  in  the 
autumn  of  1919?    Why? 

1 1 .  Why  could  not  a  curtailment  of  stock  exchange  speculation  suflBce 
to  relieve  the  monetary  strain  during  the  upward  swing  of  the 
business  cycle  ? 

12.  It  was  urged  by  many  that  an  increase  in  production  together 
with  a  decrease  in  consumption  was  aU  that  was  necessary  to 
bring  about  a  substantial  reduction  in  prices  and  a  consequent 
easing  of  the  tension  in  the  money  market.  Judging  from  the 
analysis  of  business  cycles  in  the  preceding  chapter,  do  you 
gather  it  is  possible  to  secure  an  increase  in  the  efficiency  of 
labor  and  capital  at  the  height  of  a  period  of  prosperity  ? 

13.  If  the  increased  production  is  attained,  not  as  a  result  of  increased 
efficiency  within  particular  plants,  but  only  in  consequence  of 
hiring  hitherto  vmemployed  labor  and  new  immigrants  to  engage 
in  additional  production,  would  there  be  any  decrease  in  the 
demand  for  bank  funds  ?  . 

14.  Judging  from  your  previous  study  of  business  cycles,  do  you 
think  that  a  decline  in  consumptive  demand  and  an  increase  in 
production  usually  go  together  ? 

15.  Concretely,  how  ^as  it  expected  that  a  decline  in  prices  would 
affect  bank  reserves  ? 

16.  Do  you  see  any  means  whereby  a  decline  in  prices  might  have 
been  effected  without  precipitating  a  business  depression? 
Do  you  see  any  means  whereby  bank  reserves  might  have  been 
increased  without  either  a  business  depression  or  a  decline  in 
prices  ? 

17.  If  wages  and  salaries  had  everywhere  been  raised  as  fast  as  the 
cost  of  living  was  advancing,  could  not  a  decline  in  consumptive 
demand  in  the  spring  of  1920  have  been  avoided  ?  Would  this 
have  prevented  a  period  of  readjustment  ? 

18.  What  peculiar  difficulties  were  there  in  the  winter  of  1920  in  the 
way  of  an  effective  use  of  high  interest  rates  ? 

19.  "The  Federal  Reserve  System  is  panic  proof."  Do  you  agree 
with  this  unqualified  statement  ? 

20.  "There  can  be  no  credit  collapse  so  long  as  additional  funds  are 
available;  and  under  the  Federal  Reserve  System  there  is  unlimi- 
ted lending  power."    Is  this  a  true  statement  of  the  situation? 

21.  Write  a  summary  statement  of  your  conclusions  as  to  the  efficacy 
of  the  Federal  Reserve  System  as  tested  by  the  crisis  of  1920. 


648  THE  FESTANCIAL  ORGANIZATION  OF  SOCIETY 

REFERENCES  FOR  FURTHER  READING 

Laughlin,  J.  Laurence:  Banking  Progress,  chap.  xi. 

Mitchell,  Wesley  C:  "Prices  and  Reconstruction,"  American 
Economic  Review,  Vol.  X,  No.  i  (March,  1920). 

Moulton,  Harold  G.:  "Banking  Policy  and  the  Price  Situation," 
American  Economic  Review,  Vol.  X,  No.  i  (March,  1920). 

Reed,  Harold  L.:  "The  Work  of  the  Federal  Reserve  Board," 
Journal  of  Political  Economy,  XXIX,  January,  192 1. 

Federal  Reserve  Bulletin.  Consult  monthly  btilletins  for  oflScial 
pronouncements  of  the  Federal  Reserve  Board. 


CHAPTER  XXVII 

RAISING  CAPITAL  FOR  AGRICULTURE 

The  analysis  of  financial  operations  in  all  of  the  preceding 
chapters  has  related  primarily  to  the  financing  of  industry  and 
commerce,  with  only  incidental  reference  to  the  agricultural 
side  of  our  economic  life.  In  the  present  chapter  we  shall  view 
the  financial  structure  from  the  point  of  view  of  agriculture, 
noting  in  what  ways  the  financial  institutions  which  have  already 
been  considered  are  associated  with  agricultural  finance,  and 
discussing,  particularly,  the  work  of  the  numerous  special 
financial  agencies  that  have  been  evolved  for  facilitating  the 
raising  of  capital  for  agricultural  purposes. 

As  in  the  case  of  corporate  and  partnership  enterprises 
engaged  in  commerce  and  industry,  we  may  classify  farm  capital 
as  fixed  and  working,  the  fixed  capital  representing  invest- 
ments in  the  land,  buildings,  and  equipment,  and  the  working 
capital  that  utilized  in  the  yearly  operation  of  the  farm.  As  the 
chart  on  page  650  indicates,  however,  agriculture  is,  as  yet, 
almost  exclusively  conducted  on  a  non-corporate  basis;  hence 
the  instruments  utilized  and  the  financial  institutions  employed 
in  raising  fixed  capital  have  ordinarily  been  essentially  different 
from  those  used  by  industrial  and  commercial  enterprises.  We 
shall  find  that  the  most  significant  development  in  the  history 
of  agricultural  finance  has  been  the  organization  of  the  Federal 
Farm  Loan  System  by  means  of  which  fixed  capital  for  agri- 
culture may  now  be  raised  by  methods  similar  to  those  so  suc- 
cessfully employed  by  corporate  industry.  • 

A  few  words  are  necessary  by  way  of  explanation  and  ampli- 
fication of  the  chart  on  the  accompanying  page.  It  will  be 
noted  in  the  first  place  that  a  large  amount  of  working,  as  well 
as  fixed,  capital  is  supplied  directly  by  the  owners.  While,  as 
we  have  elsewhere  seen,  some  of  the  working  capital  of  indus- 
trial and  commercial  enterprises  is  necessarily  furnished  by  the 

649 


650 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


RAISING  CAPITAL  FOR  AGRICULTURE  651 

owners  of  the  business,  the  percentage  of  borrowed  working 
capital  is  typically  much  less  in  agricultural  than  in  other  lines. 

Second,  the  chart  does  not  make  clear  one  important  feature 
of  the  farm  mortgage  business.  Farms  have  been  very  com- 
monly purchased  by  the  method  of  paying  part  down  and  giving 
the  seller  a  mortgage  on  the  property  for  the  balance.  It  wilJ 
be  seen  that  no  intermediary  financial  institution  is  necessary  in 
such  a  case ;  hence  this  method  of  borrowing  could  not  well  be 
portrayed  upon  the  chart.  Many  mortgages  made  subsequent 
to  the  purchase  are  also  consummated  directly  without  the  inter- 
mediation of  any  third  person  or  institution.  This  is  indicated 
in  the  chart  by  the  straight  line  connecting  "Fixed  Capital" 
with  "Individual  Purchaser." 

Third,  it  will  be  seen  that  savings  banks  and  trust  companies 
appear  upon  the  fixed  capital  side  of  the  chart  in  two  different 
places.  In  the  upper  part  of  the  diagram  they  are  put  down 
as  distributors  of  farm  mortgages,  while  in  the  lower  part  they 
are  grouped  with  insurance  companies  as  final  purchasers  of 
mortgages,  and  also  of  farm  loan  bonds,  as  is  indicated  by  the 
lines  connecting  with  the  Joint  Stock  and  Federal  land  banks. 

It  is  necessary  to  add  a  word  of  explanation  for  placing 
cormnercial  banks  along  with  savings  banks  and  trust  companies 
as  distributors  of  farm  mortgages;  for  it  is  commonly  supposed 
that  it  is  no  part  of  the  business  of  such  institutions  to  deal  in 
mortgages.  The  truth  is,  however,  that  many  commercial 
banks  and  trust  companies  have  farm  mortgage  departments  and 
engage  in  the  bu5dng  and  selling  of  mortgages.  This  appHes 
not  only  to  the  commercial  banks  of  the  smaller  towns  but  also 
to  some  of  the  larger  institutions  of  the  financial  centers. 

Many  of  the  small  state  commercial  banks  purchase  real- 
estate  mortgages  for  investment  purposes;  and  the  trust  funds 
administered  by  trust  companies  are  in  no  small  degree  invested 
in  farm  mortgage  securities.  The  part  that  savings  banks  play 
as  purchasers  of  mortgages  may  be  seen  by  reference  to  the 
statistics  of  savings  bank  investments  as  shown  on  pages  328 
and  333.     It  will  also  be  recalled*  that  the  insurance  companies 

'  See  p.  345. 


652  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

have  offered  the  largest  single  outlet  for  the  sale  of  farm  mort- 
gages and  that  without  their  support  American  agriculture 
would  in  the  past,  at  least,  have  found  it  practically  impossible 
to  procure  the  funds  required  for  its  expansion  and  development. 
In  this  connection  it  should  be  noted  that  the  chart  does  not 
clearly  indicate  the  relative  importance  of  the  insurance  com- 
pany as  a  purchaser  of  farm-loan  securities.  On  the  other  hand, 
it  plays  up  the  Federal  Farm  Loan  System  out  of  proportion 
to  its  immediate  importance,  though  not,  it  is  beUeved,  to  its 
ultimate  significance  in  the  rural  credit  structure. 

Fourth,  a  hne  might  also  be  drawn  from  "Fixed  Capital" 
to  **  Commercial  Banks,"  for  many  loans  have  been  made  for 
fixed  capital  purposes  by  state  banks  and  trust  companies,  on 
mortgage  security,  and  by  national  banks  on  single-  or  double- 
name  promissory  notes,  indefinitely  renewed. 

Finally,  the  chart  does  not  indicate  the  work  that 
co-operative  credit  associations  perform  in  furnishing  working 
capital  for  agriculture.  A  brief  discussion  of  the  work  of  these 
institutions  is,  therefore,  in  point  at  this  place.  There  are 
numerous  co-operative  plans  in  use.  'Under  one  method,  for 
example,  dairy  farmers  enter  into  an  agreement  with  a  local 
banker,  or  other  money  lender,  to  adopt  an  approved  system  of 
dairying.  The  lenders  of  the  funds  buy  the  dairy  stock  and 
sell  it  to  the  farmers  at  actual  cost,  plus  a  percentage  to  cover 
expenses.  Under  this  method  the  lender  takes  the  farmer's 
personal  note,  with  or  without  indorsement,  or,  as  the  case  may 
be,  with  mortgage  security  on  the  stock  purchased.  Another 
plan  similar  to  this  calls  for  a  joint  guaranty  by  a  group  of  farm- 
ers that  the  loans  will  be  paid,  each  member  of  the  group  also 
assuming  individual  liabiUty  for  the  entire  loan. 

Some  very  interesting  credit  associations  have  also  been 
developed  for  making  short-time  loans  to  Jewish  farmers.  The 
Jewish  Agricultural  and  Industrial  Aid  Society  had,  in  191 3, 
seventeen  credit  unions,  all  located  in  eastern  states.  The 
orinciple  underlying  these  co-operative  associations  is  the  exten- 
sion of  credit  by  the  association  as  a  whole  to  any  member  who 
is  in  need  of  funds.    These  unions  are  quasi-philanthropic 


RAISING  CAPITAL  FOR  AGRICULTURE  653 

enterprises,  and  the  loans  are  made  at  exceptionally  low  rates 
of  interest. 

A  more  extensive  form  of  co-operative  credit  is  that  made 
possible  by  an  act  of  the  Massachusetts  legislature  in  1915. 
Under  this  law  a  group  of  seven  or  more  residents  of  the  state 
are  given  the  right  to  organize  themselves  into  a  credit  union. 
This  union  may  receive  funds  from  its  members,  either  in  pay- 
ment for  shares  of  stock  in  the  union,  or  for  deposit;  and  in 
turn  it  may  lend  to  its  members  the  funds  so  accumulated,  or 
it  may  invest  them  in  accordance  with  certain  regulations  laid 
down  by  law.  It  is  not  improbable  that  this  form  of  credit 
extension  will  gradually  come  to  play  a  larger  role  in  the  system 
of  agricultural  finance. 

With  this  preliminary  survey  of  the  problem  of  agricultural 
credit  in  mind  we  may  turn  to  a  consideration  of  the  practical 
operations  of  the  various  financial  agencies  that  are  utilized  in 
raising  funds  for  agricultural  purposes.  It  will  be  found 
expedient  to  reverse  the  order  followed  in  discussing  industrial 
and  commercial  borrowing,  and  take  up  first  the  raising  of 
working  capital. 

A.  Working  Capital 

The  working  or  operating  capital  used  in  agriculture  is  derived 
from  a  variety  of  sources — from  commercial  banks,  cattle  loan 
companies,  private  individuals,  implement  manufacturers,  can- 
ning factories,  local  merchants,  wholesale  dealers,  etc.  The 
security  back  of  farm  loans  also  assumes  a  variety  of  forms. 
For  example,  a  rough  estimate  made  in  1910^  showed  that  of  a 
total  of  $2,207,000,000  of  farm  loans  not  secured  by  real-estate 
mortgages,  $840,000,000  were  based  upon  crop  liens,  $700,000,000 
on  chattel  mortgages  on  live  stock,  farm  machinery,  or  other 
personal  farm  property,  while  $250,000,000  was  on  open  book 
accounts  with  local  merchants.  The  balance  of  $417,000,000  is 
classified  as  miscellaneous  farm  loans. 

Since  the  chart  on  page  650  is  concerned  only  with  the 
financial  structure  which  has  developed  for  the  making  of  loans 

*  See  Grover  G.  Huebner,  Agricultural  Commerce,  p.  329. 


6S4  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

in  the  form  of  funds,  it  does  not  indicate  the  very  important 
part  that  trade  credit,  or  the  sale  of  goods  on  time,  plays  in 
financing  agriculture.  Before  considering  the  short-time  loans 
negotiated  with  commercial  banks,  it  will  therefore  be  necessary 
to  make  a  brief  statement  of  the  nature  and  significance  of 
agricultural  trade  credit. 

I.    TRADE  CREDIT 

Until  comparatively  recent  times  the  farming  communities 
have  in  fact  borrowed  the  larger  portion  of  their  working  capita' 
from  other  than  banking  sources.  For  reasons  which  need  nol 
here  be  considered,  the  farmer  typically  purchased  the  supplie? 
needed  for  current  use  on  the  farm  from  the  local  stores,  paying 
for  them  in  the  autumn  after  the  sale  of  the  season's  crops. 
Such  credit  was  usually  extended  without  the  requirement  of  a 
promissory  note;  it  was  book  credit,  with  the  merchants  as  a 
rule  keeping  the  only  records.  Since  the  risks  were  relativeh- 
large,  collections  being  slow  and  uncertain,  the  merchants  neces- 
sarily added  a  substantial  amount  to  the  price  of  the  goods  in 
order  to  cover  the  risks  involved.  The  looseness  of  the  system, 
moreover,  opened  the  way  to  exorbitant  or  usurious  charges. 

The  system  of  trade  credit  has  had  its  most  extensive  develop- 
ment in  the  South,  particularly  in  connection  with  the  growing 
of  cotton  and  tobacco  by  small  land  owners  and  tenants.  Under 
this  system  a  local  merchant  or  dealer  at  the  beginning  of  the 
crop-growing  season  extends  a  line  of  credit  at  the  store  to  a 
cotton  grower,  for  example,  and  takes  a  "lien"  on  the  cotton 
crop,  or  a  chattel  mortgage  on  the  crop  plus  any  other  propert\- 
which  the  borrower  may  own.  It  is  the  custom  to  grant  a  maxi- 
mum trade  allowance  per  month,  the  amount  .varying  with  the 
community  and  with  the  color  of  the  tenant.  The  interest  is 
nearly  always  deducted  in  advance,  and  it  appears  that  the 
borrower  has,  as  a  rule,  been  greatly  overcharged  for  his  goods. 
Perhaps  the  worst  evil  of  this  system  is  the  fact  that  the  borrower 
is  virtually  at  the  mercy  of  the  storekeeper. 

Besides  the  local  merchant,  the  owner  of  the  land  not  infre- 
quently advances  the  trade  credit  to  the  tenant.    It  is  also 


RAISING  CAPITAL  FOR  AGRICULTURE  655 

sometimes  furnished  by  a  "cotton  factor"  acting  as  the  agent 
of  a  large  cotton  dealer.  In  some  cases,  moreover,  the  advance 
takes  the  form  of  actual  money  rather  than  goods.  Private 
individuals  have  in  many  communities  also  made  money  loans 
to  cotton  and  tobacco  growers. 

A  very  interesting  development  in  rural  credit  in  recent 
years  has  been  the  furnishing  of  seed  and  supphes  to  farmers  by 
fruit  and  produce  dealers,  wholesale  grocers,  canning  factories, 
etc.  It  appears  that  in  many  cases  the  advances  take  the  form 
of  actual  money — the  amount  of  the  loans  being  deducted 
from  the  price  of  the  crops,  which  are  sold  to  the  concerns  which 
have  furnished  the  capital  required. 

While  this  trade  credit  is  extended  directly  by  the  local 
merchants,  dealers,  etc.,  the  banks  nevertheless  ordinarily  play 
an  important  part  in  the  process,  for  the  local  merchants  and 
dealers  meanwhile  usually  borrow  the  funds  from  the  local  banks 
or  are  carried  by  wholesalers  and  dealers  higher  up  in  the  trade; 
in  this  event  these  latter  middlemen  borrow  heavily  from  the 
banks  of  the  larger  centers.  In  many  cases,  moreover,  particu- 
larly in  the  farm-implement  line,  the  credit  is  extended  by  the 
manufacturers  who  borrow  the  necessary  funds  fr<3m  the  banks 
of  the  financial  centers. 

This  farm-implement  credit,  it  will  be  seen,  is  ordinarily 
used  for  what  may  be  called  fixed-capital  purposes.  Much  of 
this  credit  is  extended,  however,  for  a  period  of  only  six  months, 
for  the  reason  that  many  tools  and  supplies  last  for  one  season 
only.  In  the  case  of  harvesting  machines,  however,  the  common 
practice  has  been  for  the  manufacturer  to  allow  three  years  for 
payment,  one-thirH  being  paid  in  cash  at  the  end  of  the  first 
season,  with  promissory  notes  given  for  the  balance.  These 
notes  are  usually  guaranteed  by  the  retail  dealer,  who  acts  as 
the  local  agent  for  the  manufacturer. 

While  this  system  of  selling  farm  implements  still  prevails 
to  some  extent,'  and  while  it  is  true  that  a  vast  amount  of  trade 

'  It  was  discontinued  in  19 19  by  the  International  Harvester  Company, 
in  favor  of  cash  sales,  the  farmers'  growing  affluence  making  the  change 
possible. 


656        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

credit  is  even  now  extended  to  farmers  by  local  merchants, 
recent  years  have  witnessed  marked  changes  in  agricultural- 
credit  methods.  With  the  gradual  development  of  business 
principles  in  the  conduct  of  agriculture,  which  came  with  the 
passage  of  the  frontier  and  the  intervention  of  scientific  farming, 
farmers  have  come  to  see  that  paying  cash  for  fertihzer,  seed, 
and  other  supplies,  saves  money,  even  if  the  cash  required  has 
to  be  borrowed  from  the  bank.  The  interest  paid  to  the  banks 
is  as  a  rule  substantially  less  than  the  amount  of  the  discount 
on  the  price  of  the  goods  that  is  given  for  cash  payment. 

II.    COMMERCIAL  BANK  LOANS  FOR  AGRICULTURE 

The  chart  on  page  650  indicates  that  the  operating  capital 
used  in  agriculture,  insofar  as  it  takes  the  form  of  funds  rather 
than  goods,  is  borrowed  largely  from  the  commercial  banks, 
in  the  main  directly,  but  in  part  indirectly  through  the  inter- 
mediation of  cattle  loan  companies.  These  latter  institu- 
tions, as  we  shall  see,  occupy  a  position  in  the  rural  credit 
structure  somewhat  analogous  to  that  held  by  the  commercial- 
paper  houses  and  discount  companies  in  the  commercial  credit 
system.  f 

The  gradual  change  in  farm  financial  methods  discussed 
above  revealed  that  in  many  localities  the  banking  facilities 
for  making  short-time  loans  to  farmers  were  not  wholly  satis- 
factory. Under  the  influence  of  long-established  custom,  many 
of  the  bankers  regarded  the  farmers  as  unimportant  borrowing 
constituents;  too  often  the  local  bankers  looked  merely  to  local 
industries  for  their  support.  But  the  agitation  on  the  subject 
of  rural  credits,  both  long-  and  short-term,  which  preceded  the 
passage  of  the  rural  credit  law  in  1916,  aroused  the  country 
bankers  to  the  need  of  cultivating  their  agricultural  constituents. 
The  beUef  was  widespread  in  farming  circles  at  the  time  that 
both  the  national  and  state  commercial-banking  systems  were 
designed  primarily  to  promote  industrial  and  commercial  activ- 
ity, and  that  the  farmers  of  the  country  were  being  sorely 
neglected.  The  very  high  rates  currently  paid  by  farmers  for 
short-time  loans  seemed  conclusive  evidence  on  the  point. 


RAISING  CAPITAL  FOR  AGRICULTURE  657 

While  the  charge  that  the  country  bankers  were  neglecting 
agriculture  was  unquestionably  greatly  overdone — so  far  as 
short-time  loans  were  concerned — there  was,  nevertheless,  a 
measure  of  truth  in  the  contention.  In  any  event,  fearing  the 
loss  of  an  important  and  rapidly  developing  borrowing  constitu- 
ency, as  the  fanning  communities  became  more  prosperous 
with  the  era  of  rising  prices  that  began  in  1896,  the  country 
bankers  have  become  assiduous  in  fostering  cordial  relationships 
with  their  farming  constituents.  It  is  of  note  in  this  connection 
that  the  rural  credit  law,  which  was  eventually  passed  by 
Congress  in  19 16,  did  not  concern  itself  with  short-time  agri- 
cultural credit. 

The  extension  of  banking  facilities  throughout  the  small 
towns  of  the  country  and  the  growing  interest  of  the  banker  in 
his  rural  constituents  have  been  extremely  significant  events 
in  the  history  of  American  agriculture,  for  the  bankers  are  now 
in  many  places  taking  a  vital  interest  in  the  improvement  of 
both  farming  methods  and  rural  life;  and  they  are  co-operating 
with  the  farmers  in  every  possible  way  in  furthering  agricultural 
progress.  Not  the  least  important  of  the  bankers'  services  lies 
in  the  dissemination  of  information  on  all  phases  of  agricultural 
development.  The  "farmers'  bank"  is  becoming  a  common 
institution  in  many  regions;  and  the  services  that  such  a  bank 
may  perform  in  promoting  the  interests  of  agriculture  are  of 
incalculable  importance. 

The  making  of  bank  loans  to  farmers  involves  certain 
problems  essentially  different  from  those  associated  with  com- 
mercial lending  in  the  large  financial  centers.  In  the  first  placej 
the  relations  between  banker  and  customer  are,  in  the  nature 
of  things,  personal  rather  than  impersonal;  in  the  second  place, 
the  farmer  is  seldom  in  a  position  to  furnish  even  a  rough  state- 
ment of  his  financial  condition;  and,  in  the  third  place,  ther& 
are  greater  uncertainties  in  agriculture  than  in  most  commercial 
or  industrial  lines,  weather  conditions  being  a  determining 
factor.  In  consequence,  agricultural  lending  is  still  largely 
conducted  on  old-fashioned  banking  principles.  The  banker 
drives  out  through  the  country  and  gets  a  bird's-eye  view  ot 


658        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  farm  and  of  the  condition  of  the  crops;  he  inquires  as  to 
the  amount  and  value  of  the  Hve  stock  on  hand;  and  in  general 
keeps  in  touch  with  the  character  and  habits  and  the  poHtical 
and  financial  activities  of  the  borrower  in  question. 

With  the  development  of  agricultural  accounting,  however, 
these  methods  are  changing  somewhat,  if  slowly;  and  it  is  not 
impossible  that,  under  the  conditions  that  will  obtain  when 
farming  is  eventually  conducted  on  business-like  principles, 
country-bank  methods  will  be  similar  to  those  that  now  prevail 
in  the  larger  financial  centers. 

Renewals  of  agricultural  loans  are  very  common.  Agricultural 
loans  for  working-capital  purposes  are  usually  extended  by  the 
banks  for  from  four  to  six  months,  to  coincide  with  the  crop- 
growing  period.  Because  of  the  uncertainties  involved,  both 
as  to  the  time  at  which  agricultural  produce  will  be  sold,  and  as 
to  the  amoimt  of  the  returns — which  depend  both  upon  the 
size  of  the  crop  and  the  price  at  which  it  may  be  sold — renewals 
of  agricultural  loans  are  extremely  common.  These  renewals 
are,  moreover,  not  merely  temporary  extensions;  they  are  very 
commonly  extensions  which  must  be  carried  over  for  an  entire 
year,  until  a  subsequent  crop  shall  have  been  garnered  and  sold. 
Indeed,  it  has  been  the  rule,  rather  than  the  exception,  that  at 
least  a  part  of  the  loans  extended  to  farmers  during  the  crop- 
growing  period  are  carried  over,  extended  for  an  indefinite 
number  of  years.  This  practice  is  in  part  attributable  to  the 
fact  that  the  National  Bank  Act  did  not  permit  national  banks 
to  loan  on  the  security  of  real-estate  mortgages,  in  consequence 
of  which  the  national  institutions,  in  order  to  meet  the  compe- 
tition of  the  state  banks,  made  loans  for  fixed-capital  purposes 
to  farmers  merely  on  the  security  of  their  single  or  indorsed 
promissory  notes.  In  the  nature  of  things  such  loans  usually 
had  to  be  extended  for  a  long  period  of  years. 

In  many  cases,  however,  this  constant  renewal  of  loans 
merely  betokened  a  continuous  need  of  the  farmer  for  borrowed 
working  capital.  While  unable  to  pa)'  off  a  year's  loan  in 
full,  after  meeting  living  requirements,  the  farmer  was  usually 
on  the  up-grade,  financially  speaking;    and  the  banks  were 


RAISING  CAPITAL  FOR  AGRICULTURE  659 

merely  carrying  him  during  the  years  of  his  adversity.  In  many 
other  cases  a  bad  year,  or  a  series  of  them,  necessitated  con- 
tinuous financial  aid  from  the  bankers.  While  one  may  reflect 
that  such  loose  extension  of  credit  constituted  a  very  dangerous 
financial  practice  for  commercial  banks,  it  should  be  borne 
in  mind  as  an  extenuating  circumstance  that  it  appeared  to 
the  country  bankers  to  be  incimibent  upon  them  to  assist 
agricultural  borrowers  in  times  of  adversity  when  they  needed 
assistance  most,  quite  as  much  as  to  extend  them  credit  when 
their  needs  were  less. 

On  the  whole,  it  appears  that  such  practice  has  not  occa- 
sioned an  extremely  high  mortality  rate  among  country  bank- 
ers. Like  the  banks  of  the  commercial  centers,  the  country 
institutions  do  not  ordinarily  rely  upon  maturing  loans  for 
the  necessary  liquidity  of  their  assets;  before  the  establish- 
ment of  the  Federal  Reserve  System  they  relied  upon  being 
able  to  get  assistance  from  correspondent  banks  in  times  of  credit 
strain,  through  various  methods,  as  outHned  on  pages  474-75. 
The  responsibility  for  upholding  the  financial  structure  as  a 
whole  was  thus  placed  upon  the  banks  of  the  financial  centers. 
Since  the  passage  of  the  Federal  Reserve  Act,  the  country  banks 
rely  upon  rediscounting  agricultural  paper  with  the  Federal 
Reserve  banks.'  At  the  present  time,  therefore,  the  responsi- 
bility lies  with  the  Federal  Reserve  institutions. 

III.  THE  WORK  OF  THE  CATTLE  LOAN  COMPANY 

The  cattle  loan  company  has  been  developed  to  finance 
the  raising  of  cattle,'  both  on  the  ranges  and  lq  the  feeding 
centers  of  the  corn  belt.  In  brief,  the  raison  d'itre  of  the 
cattle  loan  company  is  the  inability  of  local  banks  in  the  cattle- 
growing  and  -feeding  regions,  to  supply  the  large  volume  of 
loans  required  by  the  cattle  men.  Unlike  ordinary  agri- 
cultural operations,  cattle-raising  is  typically  conducted  on 

'  It  will  be  recalled  that  agricultural  paper  of  six  months'  duration  is 
eligible  for  rediscount  with  the  Federal  Reserve  banks. 

'  Sheep-raising  is  also  financed  to  some  and  to  an  increasing  extent  by 
methods  similar  to  those  outlined  in  this  section. 


66o  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

a  relatively  large  scale;  and  the  cattle  borrower  accordingly 
requires  loans  of  large  average  size,  so  large  that  the  entire 
lending  resources  of  local  banks  would  often  be  absorbed  by 
a  single  loan.  Since  our  banking  laws  restrict  the  volume  of 
loans  that  may  be  made  to  any  one  borrower,  and  since  in 
any  event  the  financing  of  the  cattle  industry  by  the  local 
banks  would  result  in  an  undue  concentration  of  banking 
risks,  it  is  necessary  that  the  funds  required  in  financing  the 
raising  of  cattle  be  secured  from  the  banks  of  the  financial 
centers.    This  the  cattle  loan  company  makes  possible. 

The  development  of  the  cattle  loan  companies  dates  from 
about  1900.  Before  that  time,  state  and  national  banks  did 
what  they  could  to  finance  the  cattle  industry;  and  there 
were  a  few  large  commission  firms  which  loaned  funds  to  cattle 
feeders.  But  there  was  no  adequate  machinery  for  the  investi- 
gation of  prospective  loans,  and  no  careful  supervision  of 
loans  once  consummated.  The  losses  accordingly  proved  very 
heavy  and  cattle  paper  became  very  unpopular  for  many 
years,  the  cattle  industry  meanwhile  being  handicapped  by 
the  dearth  of  funds.  But  the  growth  of  cattle  loan  companies 
which  specialize  in  the  handling  of  cattle  paper,  and  act  as 
brokers  between  the  borrowing  cattle-men  and  the  lending 
banks  of  the  financial  centers,  has  placed  the  business  upon 
a  solid  foundation. 

There  are  two  types  of  cattle  loan  companies.  First,  there 
are  those  that  are  afiiliated  with  state  or  national  banks, 
where  the  stock  is  subscribed  by  the  directors  and  stockholders 
of  the  allied  institutions.  The  officers  and  staff  of  the  bank  are 
as  a  rule  also  officers  and  staff  of  the  cattle  loan  company. 
The  purpose  of  this  type  of  organization  is  merely  to  permit 
an  expansion  of  the  bank's  activities  in  ways  that  would  not 
be  permitted  under  the  terms  of  incorporation.  Nominally 
an  independently  organized  institution,  such  a  company  is  in 
reality  but  a  department  of  an  ordinary  commercial  bank. 
The  second  type  of  cattle  loan  company  is  an  independent 
concern,  organized  and  officered  by  individuals  who  make 
this  their  sole  business. 


RAISING  CAPITAL  FOR  AGRICULTURE  66l 

Nearly  all  of  the  cattle  loan  companies  are  located  in  the 
large  packing  centers,  although  there  are  a  few  on  the  Pacific 
coast  and  in  New  Mexico.  The  affiliated  companies  are  usually 
connected  with  some  of  the  large  Hve-stock  national  banks 
located  in  the  packing  centers  and  ordinarily  owned  and  con- 
trolled by  some  of  the  large  packers.  Such  location  has  advan- 
tages in  that  the  cattle  can  often  be  inspected  in  the  packing 
centers,  while  the  marketing  of  stolen  cattle  can  more  easily  be 
detected.  The  packing  centers  are,  moreover,  the  focal  points 
of  all  important  developments  affecting  the  cattle  industry,  and 
hence  the  policy  of  the  company  can  be  adjusted  more  promptly 
to  meet  the  changing  conditions  in  the  industry. 

Cattle  loans  are  of  several  different  types.  They  are  usually 
classified  as  follows:  (i)  ranch  loans,  on  herds  of  cattle  which 
are  being  grass-fed  on  the  ranches;  (2)  feeder  loans,  on  steers 
which  are  entering  upon  the  last  stage  of  feeding  prior  to  their 
sale  as  beef  cattle;  (3)  stocker  loans,  on  cattle  held  for  breeding 
purposes;  (4)  dairy  loans,  made  for  the  purchase  of  dairy 
cattle. 

Loans  on  ranch  cattle,  which  are  found  only  in  the  western 
states,  are  not  so  popular  as  feeder  loans  for  the  reason  that 
the  risks  involved  are  ordinarily  somewhat  greater.  Where 
the  ranches  are  fenced,  however,  as  is  now  usually  the  case, 
such  loans  are  reasonably  safe.  They  are  as  a  rule  made 
for  the  summer  season,  and  are  sometimes  referred  to  as  "sum- 
mer loans";  they  are  paid  in  the  fall  out  of  the  proceeds  derived 
from  the  sale  of  the  cattle  to  packing  houses  or  to  feeders  for 
further  fattening. 

Feeder  loans  are  made  for  periods  of  from  three  to  six 
months,  according  to  the  age  of  the  steers  and  the  length  of 
time  during  which  they  are  to  be  fed.  Such  loans  are  regarded 
as  particularly  satisfactory  in  view  of  the  fact  that  the  cattle 
which  constitute  the  security  are  to  be  sold  for  cash  within 
a  relatively  short  period  of  time  and  because  the  value  of 
the  collateral  ordinarily  increases  as  the  steers  put  on 
weight  and  improve  in  quality.  Moreover,  the  dangers  from 
inclement  weaker,  disease,  aix4  accident  are  relatively  small 


662        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Such  cattle  paper,  therefore,  ranks  with  the  best  commercial 
paper. 

Stocker  loans  are  subdivided  into  loans  on  cows  and  on 
young  stock.  Loans  on  breeding  cows  are  usually  made  for 
six  months'  time  and  are  commonly  renewed  from  three  to 
four  times  if  the  conditions  continue  to  be  favorable.  Such 
loans  are  therefore  usually  regarded  as  long-time  advances; 
and  the  cows  may  in  a  sense  be  regarded  as  fixed  capital.  They 
do  not  enjoy  the  same  standing,  therefore,  as  feeder  loans; 
and  a  larger  margin  of  security  is  required,  the  loan  commonly 
being  made  for  only  50  or  60  per  cent  of  the  total  value  of 
the  cows,  whereas  in  the  case  of  feeders,  the  loan  is  made  up 
to  90  per  C€nt  and  sometimes  even  to  100  per  cent  of  the  value. 
The  mortgage  on  the  cows  also  covers  the  offspring.  The 
second  class  of  stocker  loans  are  made  upon  young  steers  and 
heifers  intended  ultimately  to  be  marketed.  While  they  are 
made  for  periods  of  six  months,  they,  also,  are  commonly 
renewed  from  one  to  three  times.  Accordingly,  they  are 
regarded  as  of  a  less  Uquid  nature  than  the  high-grade  feeder 
loans. 

Dairy  loans,  likewise,  are  made  for  relatively  long  periods 
of  time,  and  are  usually  paid  in  monthly  instalments  from 
the  proceeds  of  the  sale  of  butter  fat.  In  consequence,  such 
loans  are  not  considered  Uquid;  and  they  cannot  be  redis- 
counted  at  the  Federal  Reserve  banks  or  be  readily  sold  out- 
side of  the  district  in  which  they  are  made.  Accordingly,  they 
are  not  commonly  made  by  cattle  loan  companies,  the  local 
banks  usually  being  reUed  upon  to  furnish  the  necessary 
accommodation . 

The  cattle  loan  company  makes  a  careful  credit  analyiis. 
Before  a  loan  is  granted  the  borrower  is  required  to  fill  out 
a  "form"  statement  furnished  by  the  cattle  loan  company 
showing  his  assets  and  Uabilities,  the  amount  of  insurance 
carried,  etc.,  and  giving  a  detailed  description  of  all  the  cattle 
which  he  has  available  as  security.  The  truth  of  the  state- 
ment is  attested  before  a  notary  public.  Second,  the  borrower 
is  required  to  fill  out  what  is  known  as  a  "brand  sheet."  which 


RAISING  CAPITAL  FOR  AGRICULTURE  663 

gives  in  both  illustrative  and  descriptive  form  the  brand 
employed  by  the  borrower.  This  permits  identification  of  the 
cattle  at  any  subsequent  time;  and  it  enables  the  lender  to 
ascertain  from  the  county  clerk  whether  any  previous  loans 
have  been  made  on  these  same  cattle.  Third,  a  careful  investi- 
gation is  made'of  the  moral  responsibility  and  financial  abiUty 
of  the  borrower.  Commercial  agencies  and  special  references 
are  used  as  sources  of  collateral  information;  and  particular 
attention  is  paid  to  the  reports  of  the  inspectors  who  are 
employed  by  the  cattle  loan  company. 

Finally,  the  borrower  is  required  to  sign  a  promissory  note 
and  give  a  chattel  mortgage  on  the  cattle,  whether  they  are 
already  in  his  possession  or  yet  to  be  purchased.  The  reason 
for  requiring  the  chattel  mortgage  on  the  cattle  is  that  the 
loan  company  is  usually  located  at  a  considerable  distance 
from  the  borrower  and  since  the  cattle  are  "movable"  property 
it  would  be  easy  for  a  dishonest  borrower  to  dispose  of  them 
without  the  knowledge  of  the  company.  It  should  be  noted 
that  by  virtue  of  the  mortgage  the  legal  title  to  the  cattle  rests 
in  the  loan  company,  and  accordingly  any  individual  who 
purchases  the  cattle  is  responsible  for  the  payment  of  the  loan. 
An  added  reason  for  the  use  of  collateral  security  in  the  case 
of  cattle  loans,  as  in  the  previous  cases  where  we  have  observed 
the  depositing  of  collateral,  is  the  convenience  of  the  process. 
The  cattle  are  intended  to  be  kept  during  the  life  of  the  loan, 
and  it  is  a  simple  matter  to  give  a  chattel  mortgage  against 
them. 

Cattle  paper  is  sold  to  the  hanks  of  the  financial  centers.  The 
cattle  loans  range  in  size  from  one  thousand  to  five  hundred 
thousand  dollars,  the  average  loan  being  in  the  neighborhood 
of  twenty-five  thousand  dollars.  The  cattle  loan  companies 
usually  hold  for  investment  some  of  the  loans  which  they  make, 
utiUzing  their  own  capital  and  surplus  in  this  way;  but  most 
of  the  paper  which  they  handle  is  promptly  transferred  to 
the  banks  of  the  financial  centers.  Like  the  commercial  paper 
houses,  cattle  loan  companies  advance  the  funds  to  the  borrower 
out  of  their  own  resources;    but,  vifllike  commercial  paper 


604  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

houses,  they  indorse  the  paper  which  they  sell.  The  paper 
is  sold  to  investors  at  a  rate  of  interest  ordinarily  about  2  per 
cent  less  than  that  paid  by  the  borrower.  This  2  per  cent 
margin  constitutes  the  principal  source  of  the  companies' 
profits. 

Large  loans  are  usually  broken  up  into  notes  of  one-,  five-, 
or  ten-thousand-dollar  denominations,  although  sometimes  a 
loan  of  fifty  thousand  dollars  or  more  is  sold  to  a  single  large 
investor.  In  such  cases  the  investor  is  given  a  duplicate 
certified  chattel  mortgage;  but  where  the  loan  is  broken 
up  into  small  denominations,  each  investor  is  given  what  is 
known  as  a  "certified  trust  receipt  of  chattel  mortgage." 
The  purchaser  of  the  cattle  paper,  however,  always  looks  to 
the  loan  company  for  payment;  and  the  companies  assume  the 
responsibihty  of  collecting  from  the  borrower. 

Cattle  loan  companies  perform  important  economic  services. 
We  have  already  seen  that  local  banks,  as  a  rule,  have  inade- 
quate lending  power  for  the  needs  of  cattle-growing  and  feeding, 
and  that  access  to  the  funds  of  the  financial  centers  is  indis- 
pensable to  the  continued  development  of  this  basic  industry. 
The  development  of  the  cattle  loan  companies  has  undoubtedly 
stimulated  the  growth  of  the  live-stock  industry  and,  in  con- 
sequence, the  improvement  of  agriculture  in  general.  For  it 
is  a  basic  principle  that  soil  fertihty  cannot  be  preserved 
indefinitely  in  the  absence  of  a  live-stock  industry. 

Finally,  in  the  words  of  one  writer, 

the  cattle  loan  company  renders  an  economic  service  to  society 
by  a  better  distribution  of  capital.  There  has  been  a  constant  tend- 
ency to  concentrate  capital  in  the  industrial  establishments  of  the 
nation  at  the  expense  of  the  producers  of  raw  foodstuffs.  This 
defect  has  been  largely  remedied  by  the  activities  of  the  cattle  loan 
companies.  In  making  capital  available  to  cattle-growers  the  loan 
companies  help  to  prevent  a  concentration  of  capital  in  the  East; 
much  of  the  money  which  would  otherwise  drift  back  to  New  York 
when  the  crop-moving  season  is  over,  being  in  the  fall  turned  by  the 
loan  companies  into  the  production  of  finished  cattle.  This  improve- 
jneut  in  the  distributioa  of  pftpj^ftj  1^^  Ipwef^  the  average  rate  of 


RAISING  CAPITAL  FOR  AGRICULTURE  665 

interest  to  cattlemen.  The  average  rate  charged  by  commission 
companies  during  the  "bonanza  period"  of  the  cattle  industry  was 
10  per  cent.  The  strain  on  the  local  banks,  moreover,  was  so  great 
following  this  period  that  there  was  Kttle  decrease  in  the  rates.  The 
advent  of  the  modern  cattle  loan  companies  with  their  improved 
methods  has  had  the  effect  of  lowering  the  average  interest  rate  at 
least  2  per  cent.  This  saving  is  obviously  a  benefit  to  the  grower 
and  augments  his  ultimate  profit.  It  is,  in  addition,  a  saving  to  the 
ultimate  consumer,  unless  a  monopoly  somewhere  intervenes  to 
prevent  the  working  of  normal  competitive  forces.* 

B.     Fixed  Capital 

I.  THE  NATURE  AND  EXTENT  OF  THE  FARM 
MORTGAGE  BUSINESS 

The  volume  of  borrowing  by  agricultural  interests  for 
fixed-capital  purposes  is  not  fully  measured  by  the  amount  of 
mortgage  and  bonded  indebtedness;  for  as  we  have  already 
seen,  commercial  and  savings  banks  have  made  many  loans  to 
agriculture  without  collateral  security.  Farm-mortgage  indebt- 
edness, however,  assumed  very  large  proportions  in  the  years 
following  the  Civil  War.  According  to  the  census  report  of 
1890,  out  of  a  total  number  of  3,142,746  farms,  cultivated  by 
their  owners,  886,957  were  subject  to  incumbrance.  There 
were  in  addition  1,624,433  tenant  farms  for  which  no  data  were 
collected.  The  aggregate  value  of  the  incumbered  farms  was 
$3,054,923,165;  and  the  outstanding  mortgages  aggregated 
$1,085,905,960,  the  three  states  of  New  York,  Iowa,  and 
Illinois  together  having  almost  one-third  of  the  total.  The 
ratio  of  mortgage  indebtedness  to  the  value  of  the  farm  varied 
among  the  different  states,  ranging  from  24.23  per  cent  in 
Utah  to  54.54  in  Mississippi,  and  averaging  35.55  per  cent 
for  the  country  as  a  whole. 

The  following  table  indicates  that  the  great  majority  of 
these  mortgages  were  incurred  for  constructive  purposes,  that 

"Forrest  M.  Larmer,  "The  Cattle  Loan  Company,"  Journal  of 
Political  ^onomy,  XXVI  (1918),  839, 


666  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

they  were  not,  as  is  so  commonly  supposed,  usually  acquired 
as  a  means  of  relieving  farmers'  families  from  distress.' 

CAUSES  OF  FARM  MORTGAGE  INDEBTEDNESS 

Percentage  of  Total 
Purpose  of  Borrowing  Indebtedness 

For  purchase  of  real  estate 64.38 

For  real  estate  improvement 4.53 

For  purchase  of  real  estate  and  improvement  thereof 

combined 5.31 

For  use  in  other  business 1.95 

For  purchase  of  farm  machinery,  domestic  animals, 

etc 1. 19 

For  farm  and  family  expenses 2.83 

While  few  such  loans  can  fairly  be  placed  in  the  "calam- 
ity" class,  it  is  true,  however,  that  during  the  long  period  of 
falling  prices  after  the  Civil  War  a  considerable  percentage  of 
the  mortgage  loans  that  would  ordinarily  have  been  paid  at 
the  end  of  the  three  or  five  years  for  which  they  were  contracted, 
were  necessarily  renewed.*  The  census  report  of  1910  indicated 
that,  notwithstanding  the  great  improvement  in  agricultural 
conditions  that  came  with  the  era  of  rising  prices  beginning 
in  1896,  the  total  mortgage  indebtedness  *in  1910  stood  at 
$2,293,000,000,  an  increase  of  no  per  cent  in  twenty  years.  In 
1915  the  United  States  Department  of  Agriculture,  computing 
on  the  basis  of  the  census  figures  of  19 10,  estimated  that  the 
total  farm-mortgage  debt  of  the  United  States  then  stood 
at  $3,598,985,000;  while  more  recent  estimates  have  placed 
the  total  in  the  neighborhood  of  $4,000,000,000.  These  in- 
creases in  farm  indebtedness  since  1890  have  been  mainly 
incurred  in  financing  the  purchase  and  improvement  of  agri- 
cultural property. 

'  Data  taken  from  report  on  "  Farms  and  Homes:  Proprietorship  and 
Indebtedness,"  Eleventh  Census  of  the  United  Stalf^s,  1890. 

'  See  question  No.  17  on  p.  38  above,  and  the  dis<;ussion  on  pp.  33-35, 


RAISING  CAPITAL  FOR  AGRICULTURE  667 

II.    INSTITUTIONS  UTILIZED  IN  MARKETING 
FARM  MORTGAGES 

111  discussing  the  raising  of  fixed  capital  for  agricultural 
purposes  it  will  be  necessary  to  consider  first  the  financial 
machinery  employed  before  the  organization  of  the  Federal 
Farm  Loan  system,  in  1916.  The  financial  structure  that  had 
been  developed  up  to  that  time  is  indicated  in  the  chart  on 
page  650;  it  includes  everything  on  the  fixed-capital  side  of  the 
diagram  except  the  National  Farm  Loan  associations,  Federal 
Land  banks,  and  Joint  Stock  Land  banks.  It  should  be  borne 
in  mind  that  this  rural  credit  structure  remains,  even  though 
a  new  agricultural  credit  system  has  been  devised. 

While  savings  and  commercial  banks  and  trust  companies 
often  act  as  middlemen  in  the  disposition  of  mortgages,  as  is 
indicated  in  the  chart  on  page  650,  the  larger  part  of  the  farm- 
mortgage  business  is  handled  by  local  farm-mortgage  brokers 
and  by  mortgage  companies,  comparable  to  the  investment 
banking  institutions  considered  in  chapter  xiv  above.  In  the 
early  days  of  farm  borrowing  the  local  mortgage  broker  was 
practically  alone  in  the  field.  But  as  the  farm-mortgage 
business  became  more  extensive,  mortgage  companies  operating 
on  a  much  larger  scale  an(>  employing  somewhat  different 
methods  have  assumed  a  position  of  major  importance. 

I.  The  local  farm  mortgage  broker.  The  farm  mortgage 
broker  has  his  office  in  the  center  of  an  agricultural  community 
and  seldom  extends  the  scope  of  his  operations  beyond  the 
limits  of  a  single  county.  His  function  is  merely  to  bring  the 
farm  borrower  and  the  city  lender  together;  he  does  not  advance 
any  funds  to  the  farmer  or  indorse  the  mortgage,  which  is 
made  out  directly  to  the  purchaser.  The  profit  of  the  farm- 
mortgage  broker  is  derived  from  the  difference  between  the 
rate  of  interest  which  the  farm  borrower  pays  and  the  rate  at 
which  the  mortgage  is  sold  to  the  investor.  In  the  early  days 
before  the  development  of  competing  mortgage  companies  the 
brokers  commonly  secured  very  large  profits, 


668  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

2.  The  farm  mortgage  company.  The  mortgage  companies 
conduct  their  operations  on  a  much  larger  scale  than  do  the 
brokers.  Through  a  system  of  local  agents  they  solicit  mort- 
gages throughout  an  entire  state  and  in  some  cases  in  more  than 
one  state.  They  also  utilize  the  independent  mortgage  brokers 
in  getting  in  touch  with  borrowing  constituents. 

In  making  a  mortgage  loan  under  this  system  the  prospective 
borrower  fills  out  an  application  blank  furnished  by  the  local 
agent.  This  appUcation  usually  calls  for  information  upon  the 
following  points:  (i)  the  amount  of  the  property  to  be  mort- 
gaged that  is  under  cultivation;  (2)  date  of  purchase;  (3)  the 
amount  of  present  incumbrance,  if  any;  (4)  the  nature  and 
cash  value  of  improvements  that  have  been  made  on  the  land; 
(5)  the  present  cash  value  of  the  land;  (6)  crops  of  the  previous 
and  current  year;  (7)  the  rental  value;  (8)  the  location  of  the 
land  with  respect  to  railroads,  towns,  schools,  churches,  etc.; 

(9)  the  assessed  valuation  and  the  amount  of  the  tax  thereon; 

(10)  the  amount  of  hve  stock  on  the  premises;  (11)  the  total 
valuation  of  the  borrower's  property,  both  real  and  personal; 
(12)  the  state  of  the  title  to  the  property;  and  finally,  (13)  the 
purpose  for  which  the  money  is  to  be  borrowed.  The  local 
agent  of  the  mortgage  company  and  two  or  more  disinterested 
local  residents"  are  required  to  indorse  on  the  application  blank 
their  sworn  appraisal  of  the  value  of  the  land.  Upon  receipt 
of  the  appUcation- the  mortgage  company  sends  an  agent  to 
inspect  the  property  and  make  a  report.  If  this  report  is 
favorable  an  agreement  is  reached  as  to  the  rate  of  interest  and 
the  conamission,  and  the  mortgage  is  then  ready  for  sale.  The 
rate  of  interest  is  usually  the  lowest  that  will  insure  the  sale  of 
the  mortgage  at  par  in  the  financial  centers. 

The  conunission  received  by  the  mortgage  company  is 
most  frequently  in  the  form  of  a  lump  sum  deducted  from  the 
proceeds  derived  from  the  sale  of  the  mortgage.  But  another 
conmion  method  is  to  make  the  commission  payable,  in  the 
case  of  a  five-year  mortgage,  in  ten  semi-annual  instalments 
secured  by  the  borrower's  notes  and  a  second  mortgage  on  the 
property,    Uwder  thi?  method,  io  case  any  instalment  is  not 


RAISING  CAPITAL  FOR  AGRICULTURE  669 

paid,  the  entire  commission  automatically  becomes  due.  The 
commissions  received  by  the  mortgage  companies  have  been 
large,  particularly  in  the  earlier  days;  it  is  said  that  for  many 
years  such  companies  never  received  commissions  of  less  than 
10  per  cent  of  the  amount  of  the  mortgage.  It  may  be  added 
that  real-estate  mortgages  usually  run  for  either  three  or  five 
years;  and  since  the  mortgages  are  very  commonly  renewed, 
additional  commissions  are  commanded  for  securing  extensions. 
Finally,  it  may  be  noted  that,  in  addition  to  the  commission 
received  by  the  mortgage  company,  the  local  agent  or  broker 
charges  the  borrower  whatever  the  traffic  will  bear! 

In  making  loans  the  mortgage  companies  follow  a  method 
somewhat  different  from  that  of  the  local  farm  loan  brokers. 
The  mortgage  is  commonly  made  out,  not  to  the  purchaser  direct, 
but  to  the  mortgage  company,  which  assigns  it  to  a  purchaser 
when  one  is  found.  The  mortgage  companies  sometimes 
guarantee  the  mortgages  which  they  handle,  and  sometimes 
they  do  not.  In  the  event  of  a  foreclosure  of  a  guaranteed  loan, 
the  company  takes  possession  of  the  property  and  pays  the 
borrower  out  of  its  own  funds,  recouping  through  the  sale  of 
mortgaged  property.  In  the  case  of  non-guaranteed  loans, 
there  is  no  liability  upon  the  mortgage  company,  but,  never- 
theless, it  often  assumes  the  debt  and  takes  possession  of  the 
land.  The  purchaser  of  the  mortgage  is  usually  agreeable  to 
such  a  procedure,  for  it  relieves  him  of  the  trouble  involved  in 
making  a  settlement.  It  is  said  that  large  profits  have  been 
made  by  the  mortgage  companies  from  the  sale  of  land  taken 
under  foreclosure  proceedings. 

There  are  numerous  provisions  designed  to  protect  the 
purchaser  of  the  mortgage.  The  borrower  is  required  to 
assure  the  payment  of  the  taxes  and  to  keep  the  buildings 
insured  for  the  benefit  of  the  mortgagee.  In  case  of  a  default 
in  the  payment  of  interest,  or  in  the  performance  of  an}^  of  the 
agreements,  the  lender  may  declare  the  entire  debt  immediately 
due.  It  may  be  added  that  if  the  borrower  succeeds,  in  such 
a  case,  in  securing  funds  with  which  to  make  up  arrears  and 
have  the   loan   reinstated,   the   mortgage    company   receives 


670         tHE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

a  further  commission  or  bonus  for  its  service  in  reinstating 
the  loan. 

Many  mortgage  companies  issue  debenture  bonds.  Instead 
of  assigning  the  mortgages  directly  to  investors  many  companies 
issue  their  own  debentures,  secured  by  the  mortgages  which 
the  company  has  purchased.  Such  mortgages  are  assigned  to  a 
trust  company,  which  holds  them  for  the  protection  of  the 
purchasers  of  the  debentures.  It  should  be  noted  that  the 
purchaser  also  has  a  creditor  claim  against  all  the  assets  of 
the  mortgage  company,  which  are  usually  invested  in  mortgages. 
The  holder  of  a  mortgage  that  is  guaranteed  by  a  mortgage 
company  is  similarly  protected  by  the  company's  own  invest- 
ments. 

There  are  some  serious  weaknesses  in  the  farm-mortgage 
system.  The  biggest  source  of  danger  in  the  making  of  farm 
loans  lies  in  the  local  agency  system.  Says  one  writer  of  the 
activities  of  the  local  agents:^ 

Their  earnings  depend  on  their  making  loans,  and  the  size  of  the 
commission  depends  upon  the  size  of  the  loan.  Local  agents  and 
examiners  from  the  home  ofl&ce  are  sometimes  bribed  to  overvalue 
the  land.  The  sworn  appraisement  by  householders  resident  in  the 
county  where  the  land  lies  by  no  means  secures  in  every  case  what  it  is 
meant  to  secure.  The  dishonest  borrower  always  knows  who  in 
the  community  entertains  the  wildest  notions  about  the  future 
of  his  county  or  town,  and  this  man  makes  the  sworn  appraisement; 
and  there  is  a  wide  difference  between  the  appraisal  made  by  really 
honest  men  "for  loan  purposes,"  and  the  appraisal  made  by  the 
same  men  in  their  actual  buying  and  selling. 

While  the  majority  of  the  farm-mortgage  companies  have 
always  been  managed  by  men  of  high  integrity  and  conducted 
on  sound  business  principles,  tlie  large  profits  obtainable  in 
the  business,  particularly  during  periods  of  land  speculation, 
have  led  to  the  organization  of  many  irresponsible  and  dishonest 
companies.  Such  companies  offer  very  high  rates  on  iportgages 
on  which  they  give  their  worthless  guaranty.  And  in  order  to 
secure  large  commissions  they  make  loans  far  in  excess  of  the 

'  James  Willis  deed,  Forum,  IX  (1890),  100. 


RAISING  CAPITAL  FOR  AGRICULTURE  67 1 

value  of  the  land  which  is  offered  as  security.  Such  practices, 
it  is  needless  to  say,  result  not  only  in  inevitable  loss  to  investors 
but  also  in  discrediting  the  mortgage  business  in  general. 

The  following  typical  advertisement  of  an  investment 
offering  of  a  farm-mortgage  company  will  indicate  in  a  general 
way  the  nature  of  the  security  that  is  given: 

J.  A.  B.  Coupon  Notes  $5,000.00 

A  series  of  Ten  (10)  coupon  notes,  in  denominations  of  $500.00 
each,  dated  January  19,  1916,  maturing  January  19,  1921;  bearing 
interest  at  the  rate  of  65  per  cent  per  annum,  interest  payable  semi- 
annually to  the Trust  Company, ,  Texas;  all  equally 

secxured  by  first  mortgage  to  the  Trust  Company  on  241 

acres  of  land  in  W.  County,  Texas,  about  eight  miles  southeast  of  W. 

The  land  is  all  imder  good  fence,  wire  and  post.  About  50  per 
cent  of  it  is  good,  black,  waxy  soil;  the  balance  is  black  sandy  loam 
— all  good,  rich  soil.  About  150  acres  are  in  cultivation,  probably 
60  acres  being  put  in  for  the  first  time  this  year.  Of  this  cultivated 
land,  about  75  acres  were  originally  black  waxy  prairie,  now  in  good 
state  of  cultivation;  about  75  acres  were  originally  bottom  timber 
land,  probably  30  acres  put  in  cultivation  in  191 5,  the  balance  being 
put  in  this  year.  The  tract  is  practically  level;  has  one  small  drain 
or  slough  running  through  it,  which  adds  materially  to  the  drainage. 

The  improvements  consist  of  three  three-room  box  tenant 
houses  and  one  two-room  box  house,  recently  completed. 

Mr.  B.  states  that  it  is  his  intention  to  put  the  entire  tract  in 
cidtivation  except  probably  25  acres,  which  he  will  use  for  pasturage 
and  wood  for  tenants. 

The  place  is  watered  by  wells.  The  tract  lies  in  Caney  Valley, 
but  is  not  subject  to  overflow. 

Improved  lands  in  this  vicinity  sell  at  $60.00  to  $100.00  per 
acre.  Our  appraiser  considers  this  tract  worth  $45.00  per  acre,  or 
a  total  of  $10,845.00. 

We  offer  these  notes  at  par  and  accrued  interest,  accompanied, 
by  our  written  guarantee. 

&  Co.,  Bankers 

Founded  A.D.  1858 

Many  of  the  farm  mortgage  companies  have  in  recent  years 
issued  coupon  notes  and  bonds  in  denominations  convenient 


672  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

for  the  purchaser  of  small  means,  the  mortgage  being  held 
"in  trust"  after  the  fashion  of  corporate  mortgages.  In  some 
instances  also,  the  bonds  run  for  long  periods  of  time,  rather 
than  for  three  or  five  years  merely,  in  which  event  the  amorti- 
zation principle  of  paying  off  the  mortgage  is  usually 
incorporated.^ 

The  farm  mortgage  companies  have  in  recent  years  grown 
rapidly  in  number,  size,  and  influence.  They  are  now  united 
in  a  Farm  Mortgage  Bankers'  Association  of  America,  composed 
of  about  two  hundred  members,  including  banks  and  trust 
companies  with  mortgage  departments.  The  purpose  of  the 
association  is  to  raise  the  standard  of  mortgage-bank  practice, 
promote  constructive  farm-mortgage  legislation,  and  oppose 
legislation  regarded  as  inimical  to  their  own  and  to  the  general 
welfare.  During  the  last  two  years,  for  example,  the  asso- 
ciation has  conducted  a  vigorous  campaign  against  the  Federal 
Farm  Loan  System.* 

III.    THE  FEDERAL  FARM  LOAN  SYSTEM 

The  agricultural  credit  structure  that  has  been  described  in 
the  preceding  pages  was  never  regarded  with  favor  by  the 
farmers  of  the  country.  The  interest  rates  that  prevailed  in 
many  sections  of  the  country  were  very  high — ^in  the  view  of 
the  farmer  exorbitantly  high — while  the  commissions,  legal 
fees,  and  renewal  charges  greatly  increased  the  actual  cost  of 
the  funds  secured.  This  situation,  together  with  the  agri- 
cultural depression  that  prevailed  more  or  less  continuously 
from  the  end  of  the  Civil  War  until  the  late  nineties,  was  in  no 
small  measure  responsible  for  the  greenback  and  free-silver 
movements  of  that  period.  While  the  general  prosperity  that 
began  in  1897  and  continued  almost  uninterruptedly  for  a 
decade  served  to  quiet  for  a  time  the  farmers'  discontent  with 

'  For  an  illustration  of  the  amortization  principle  see  p.  679. 

*  See  pp.  688-89  for  a  discussion  of  the  basis  of  the  opposition  to  the 
Federal  Farm  Loan  System. 


RAISING  CAPITAL  FOR  AGRICULTURE  673 

monetary  conditions,  there  nevertheless  remained  a  deep- 
seated  conviction  that  agriculture  was  seriously  handicapped 
by  virtue  of  inadequate  credit  facilities. 

An  insistent  agitation  for  the  reduction  of  rates  on  agri- 
cultural loans  and  for  an  improvement  in  the  general  conditions 
on  which  credit  is  extended  to  farmers  began  about  ten  years 
ago.  At  that  time  the  movement  for  the  establishment  of  a 
"panic-proof"  commercial  banking  system  was  already  well 
under  way;  and  an  improved  agricultural  credit  system  appeared 
to  be  a  necessary  complement.  The  agitation  was  given  a 
great  impetus  by  the  timely  appearance  of  a  number  of  striking 
articles,  which  indicated  that  farmers  in  many  sections  of  the 
country  were  paying  from  8  to  12  per  cent  for  money,  as  con- 
trasted with  rates  in  our  industrial  centers  of  only  4  or  5  per 
cent.  It  was  also  pointed  out  repeatedly  that  farm  loans  in 
Europe  could  be  secured  in  unlimited  quantity  at  rates  varying 
from  3  to  5  per  cent. 

While  much  of  the  agitation  on  the  subject  of  rural  credits 
is  due  to  false  assumptions  and  to  an  inadequate  grasp  of  the 
principles  governing  the  rates  of  interest  on  different  classes 
of  loans,  there  was  unquestionably  just  cause  for  complaint. 
Because  of  an  inadequate  organization  of  credit  machinery, 
agricultural  loans  bore  unnecessarily  high  rates  of  interest; 
while  the  short  term  for  which  mortgages  were  made  commonly 
necessitated  the  payment  of  additional  legal  fees  and  renewal 
commissions,  for  which  there  was  no  sound  economic  reason 
whatever. 

As  a  means  of  affording  relief  numerous  proposals  were 
advanced,  the  most  popular  of  which  was  the  making  of  govern- 
ment loans  direct  to  farmers  at  merely  nominal  rates  of  interest, 
one  or  two  per  cent,  the  doctrine  that  the  government  should 
"do  something"  for  agriculture,  the  nation's  basic  industry, 
always  finding  many  eager  adherents.  Sounder  ideas  eventu- 
ally prevailed,  however,  and  the  advocates  of  self-reliance  and 
self-help  won  the  day.  The  ultimate  outcome  was  the  authori- 
zation in  19 16  of  a  Federal  Farm  Loan  System,  modeled  after 
the  Federal  Reserve  System. 


674  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  Federal  Farm  Loan  Act  passed  on  July  17,  1916, 
marked  the  beginning  of  a  new  era  in  agricultural  finance. 
In  brief,  the  purpose  of  the  law  is,  through  an  improved  organi- 
zation of  credit  facilities,  to  raise  the  credit  standing  of  farm 
borrowers,  to  reduce  commissions  and  legal  fees,  to  lessen  and 
equaUze  interest  rates,  and  to  enlarge  the  supply  of  funds 
available  for  agricultural  development.  In  pursuance  of  this 
task  the  law  provides  for  the  organization  of  (1)  Federal  Land 
banks  and  National  Farm  Loan  associations;  and  (2)  Joint 
Stock  Land  banks.  The  former  constitute  the  distinctive 
feature  of  the  rural  credit  system;  the  provision  for  the  latter 
marks  an  attempt  to  develop  private  mortgage  companies 
under  constructive  governmental  supervision. 

I.  Administrative  framework  of  the  system.  The  rural  credit 
system  is  under  the  general  supervision  of  the  Federal  Farm 
Loan  Board,  composed  of  the  Secretary  of  the  Treasury  (ex 
officio)  and  four  other  members,  appointed  by  the  President 
with  the  approval  of  the  Senate.  The  members  serve  for 
eight  years  and  receive  a  salary  of  $10,000  per  annum,  together 
with  necessary  traveling  expenses.  The  duties  of  the  Farm 
Loan  Board  are  analogous  to  those  of  the  Federal  Reserve 
Board  and  the  Comptroller  of  the  Currency  in  connection  with 
the  national  banking  system.  In  brief,  they  supervise  tlie 
chartering  and  organizing  of  Federal  Land  banks.  Farm  Loan 
associations,  and  Joint  Stock  Land  banks,  regulate  interest 
rates  and  other  charges  on  loans,  supervise  the  issue  of  Farm 
Loan  bonds,  conduct  examinations  of  the  banks  in  the  system 
and  pubUsh  annual  reports,  which  show  the  condition  of  the 
various  farm  loan  institutions  and  present  such  additional  data 
as  may  have  a  bearing  upon  agricultural  credit  in  general. 

The  act  provided  that  continental  United  States  should  be 
divided  into  twelve  districts,  in  each  of  which  should  be  located 
a  Federal  Land  bank.  In  creating  these  districts  the  organi- 
^tion  committee  endeavored  to  group  together,  as  far  as 
possible,  states  of  diverse  character  and  development,  as  a 
pieans  of  minimizing  the  results  of  a  crop  failure  in  any  one 
region.    In  determining  the  location  of  the  farm  loan  bank  in 


RAISING  CAPITAL  FOR  AGRIOJLTURE  675 

each  district  the  Board  sought  to  secure  (i)  reasonable  approxi- 
mation to  the  geographical  center  of  the  district;  (2)  prompt 
and  frequent  train  and  mail  service;  (3)  climatic  conditions 
that  would  not  impair  the  health  of  the  officials;  (4)  congenial 
environment.  As  a  rule  the  larger  cities  were  not  selected; 
but  rather  those  which  had  already  shown  an  interest  in  agri- 
cultural development,  or  had  been  disappointed  in  not  being 
selected  as  sites  for  Federal  Reserve  banks.  The  map  on  page 
676  shows  the  district  boundaries  and  the  cities  within  which 
the  Federal  Land  banks  have  been  located. 

2.  Federal  Land  banks.  Each  Federal  Land  bank  is  man- 
aged by  a  board  of  nine  directors:  six  of  them  local  directors, 
elected  by  the  farm-loan  associations  of  the  district;  and  three 
of  them  district  directors,  appointed  by  the  Federal  Farm  Loan 
Board.  The  capital  stock  of  each  bank,  required  before 
beginning  operations,  is  $750,000,  divided  into  shares  of  $5.00 
each,  which  may  be  subscribed  for  by  any  person,  firm,  cor- 
poration, or  state,  or  by  the  United  States.  The  law  holds 
that  any  part  of  the  capital  stock  which  is  not  subscribed  for 
within  thirty  days  shall  be  subscribed  by  the  United  States 
government.  Stock  that  is  owned  by  the  government,  however, 
receives  no  dividends. 

3.  National  Farm  Loan  associations.  The  Federal  Land 
banks  occupy  a  position  in  the  rural-credit  system  similar  to 
that  of  the  Federal  Reserve  banks,  while  the  National  Farm 
Loan  associations,  authorized  by  the  rural  credit  law,  may  be 
regarded  as  analogous  to  the  individual  member  banks  of  the 
Federal  Reserve  System.  They  differ  from  the  member  banks 
in  one  very  important  particular,  however,  namely,  that  they 
are  co-operative  associations  organized  by  a  group  of  farmers 
for  the  specific  purpose  of  securing  credit  through  the  Federal 
Land  bank;  they  are  not  privately  organized  institutions 
conducting  a  general  banking  business,  as  is  the  case  with  the 
units  of  the  Federal  Reserve  System. 

The  law  provides  that  "ten  or  more  natural  persons  who 
are  the  owners,  or  about  to  become  the  owners,  of  farm  land 
qualified  as  security  for  a  mortgage  loan  under  this  Act,"  may 


676 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


RAISING  CAPITAL  FOR  AGRICULTURE  677 

unite  to  form  such  a  National  Farm  Loan  association.  No 
persons  except  borrowers  on  farm-loan  mortgages  may  become 
members  or  borrowers.  The  management  of  the  association  is 
vested  in  a  board  of  five  directors.  The  capital  stock  varies 
with  the  volume  of  loans  secured,  one  share  of  stock  being  issued 
for  every  loan  of  $200  (or  major  portion  thereof).  Thus  the 
borrowers  may  receive  dividends  in  case  any  are  earned  by 
the  association.  The  shareholders  are  "held  individually 
responsible,  equally  and  ratably,  and  not  one  for  another," 
for  all  debts  and  obligations  to  double  the  amount  of  their 
stock  holdings. 

4.  Method  of  making  loans.  When  an  application  for  a  loan 
is  submitted  to  a  National  Farm  Loan  Association,  a  loan  com- 
mittee of  the  association  appraises  the  value  of  the  property 
and  makes  a  detailed  report  on  the  project.  No  loan  may  be 
approved  by  the  directors  of  the  farm  loan  association  unless 
all  three  members  of  the  loan  committee  recommend  it;  and 
before  the  loan  is  finally  granted,  it  must  also  be  approved  by 
an  appraiser  of  the  Federal  Land  bank  from  which  the  funds 
are  to  be  secured. 

In  case  the  loan  is  approved,  the  farm  loan  association 
subscribes  for  capital  stock  in  the  Federal  Land  bank  of  its 
district  to  an  amount  equal  to  5  per  cent  of  the  loan  desired; 
the  stock  is  hypothecated  with  the  Federal  Land  bank  as 
partial  collateral  security  for  the  loan.  The  farm  loan  asso- 
ciation then  indorses  a  first  mortgage,  which  it  has  received 
from  the  borrowing  member,  over  to  the  Federal  Land  bank, 
thus  assuming  a  secondary  liability  for  the  payment  of  the 
obhgation. 

The  Federal  Land  bank  advances  the  funds  to  the  farm 
loan  association  and  issues  its  own  debentures  known  as  "farm 
loan  bonds, "  for  sale  in  the  general  investment  market.  These 
bonds  are  issued  only  under  specific  authorization  of  the  Federal 
Farm  Loan  Board.  For  purposes  of  administration  each  dis- 
trict has  a  Farm  Loan  Registrar  (corresponding  to  the  Federal 
Reserve  Agent  of  the  Federal  Reserve  System),  appointed  by 
the  Federal  Farm  Loan  Board.      When  any  Federal  Land 


678  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

bank  desires  to  issue  bonds,  it  must  deposit  the  mortgages 
which  have  been  taken  from  borrowers  with  the  Registrar, 
to  whom  they  are  assigned  in  trust  as  collateral  for  the 
bonds. 

The  mortgage  must  always  be  a  first  lien  on  property  owned 
by  the  borrower,  and  cannot  exceed  50  per  cent  of  the  value 
of  the  land  for  agricultural  purposes,  and  20  per  ceiit  of  the 
value  of  the  permanent  insured  improvements.  Incidentally, 
individual  loans  may  not  be  for  less  than  $100  or  for  more 
than  $10,000  in  amount,  and  a  charter  may  not  be  granted  to 
any  farm  loan  association  unless  the  total  of  loans  applied  for 
is  at  least  $20,000.  No  loans  shall  be  made  to  any  person 
who  is  not  at  the  time,  or  shortly  to  become,  engaged  in 
the  cultivation  of  the  farm  mortgaged;  and  the  borrowing 
must  be  for  one  of  the  following  purposes:  (a)  to  provide 
for  the  purchase  of  land  for  agricultural  purposes;  (b)  for 
the  purchase  of  equipment,  fertilizers,  and  live  stock  neces- 
sary for  the  proper  and  reasonable  operation  of  the  mort- 
gaged farm;  (c)  for  buildings  and  improvement  on  farm 
land;  and  (d)  to  liquidate  indebtedness  incurred  for  pur- 
poses (a),  (b),  and  (c). 

Loans  are  made  only  on  the  amortization  principle.  Added 
security  is  afforded  to  the  lender  by  virtue  of  the  fact  that  all 
loans  must  be  discharged  through  amortization  payments. 
Under  this  method  each  annual  or  semi-annual  payment  by 
the  borrower  must  include,  besides  interest  on  the  loan,  such  an 
additional  fund  as  will  amortize,  or  liquidate,  the  debt  within 
an  agreed  period,  not  less  than  five  years  nor  more  than  forty 
years.  It  is  also  provided  that,  after  five  years  from  the  date 
of  the  loan,  additional  payments  of  $25,  or  multiples  thereof, 
may  be  made;  or,  if  the  borrower  desires,  he  may  pay  off  on 
any  instalment  date  the  entire  remaining  principal.  The 
table  on  page  679  shows  how  a  $1,000  loan  at  5^  per  cent  interest 
may  be  amortized  in  35  years  by  means  of  annual  instalments 
of  $65,  which  includes  interest  and  a  partial  payment  on  the 
principal.  Thirty-five  years  is  recommended  by  the  board  as 
a  preferable  duration  for  agricultural  loans. 


RAISING  CAPITAL  FOR  AGRICULTURE 


679 


It  will  be  seen  that  under  this  system  the  margin  of  security 
back  of  the  loan  gradually  increases.  The  amortization  system 
also  has  the  very  decided  advantage  that  it  enables  the  borrower 

AN  AMORTIZATION  TABLE* 


Payment  No. 


Instalment 


Interest 


Applied  on 
Principal 


Principal  Still 
Unpaid 


2 

3 
4 
5 
6 

7 
8 

9 
10 
II 
12 
13 
14 
IS 
16 

17 
18 

19 
20 
21 
22 

23 

24 

25 
26 
27 
28 
29 
30 
31 
32 
53 
34 
35 


P65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
65.00 
62.50 


$55- 00 
54-45 
53-87 
53-26 
52.61 

51-93 
51.21 

50-45 
49-65 
48.81 
47.92 
46.98 
45-99 
44-94 
43-84 
42.68 

41.45 
40-15 
38.79 
37-34 
35-82 
34.22 
32-52 
30.64 
28.85 
26.87 
24.77 
22.56 
20.22 
17.76 
15.16 
12.42 
9-53 
6.48 
3-76 


$10.00 
10.55 
11.13 
11.74 
12.39 
13.07 
13.79 
14.55 
15.35 
16.19 
17.08 
18.02 
19.01 
20.06 

21. 16 
22.32 

23-55 
24.85 
26.21 
27.66 
29.18 
30.78 
32.48 
34-36 
36.15 
38.13 
40.23 
42.44 
44.78 
47-24 
49.84 
52-58 
55-47 
58-52 
59-24 


$2,272.50 


$1,272.50 


SI, 000. 00 


15990.00 

979-45 
968.32 

956.58 
944.19 
931.12 

917.33 
902.78 

887.43 
871.24 

854.16 
836.14 
817.13 
797.07 
775.91 
753.59 
730.04 
705.19 
678.98 
651.36 
622.14 
591.36 
558.88 
524.62 
488.47 
450.34 
410. II 
367-67 
322.89 

275-65 
225.81 

173-73 
117.76 

59.24 


♦Treasury  Department,  Federal  Farm  Loan  Bureau  Circular  No.  7,  p.  9. 

to  pay  off  the  loan  out  of  current  funds,  with  the  result  that  he 
scarcely  feels  the  burden  of  discharging  the  obligation.  Under 
the  old  system  of  three-  and  five-year  mortgages,  the  farm 


68o  THE  FINANCIAL  OR(iANIZATION  OF  SOCIETY 

borrower  usually  made  no  preparation  for  pa3anent  until  the 
mortgage  was  about  due;  whereupon  the  preparation  commonly 
consisted  in  merely  making  arrangements  for  a  necessary 
renewal,  involving,  as  we  have  seen,  substantial  additional 
legal  fees  and  commissions.  Under  the  amortization  plan 
the  farmer  is,  in  effect,  compelled  to  save  enough  each  year  to 
provide  for  the  eventual  liquidation  of  the  debt.  The  amorti- 
zation system  is  analogies  to  the  provision  of  a  sinking  fund 
for  the  liquidation  of  corporate  indebtedness.* 

Every  farm  mortgage  bond  is  the  obligation  of  all  the  Federal 
Land  banks.  The  bonds  that  are  issued  against  the  farm 
mortgages  as  collateral  are  the  direct  obligation  not  only  of 
the  Federal  Land  bank  that  issues  it  but  of  the  entire  twelve 
land  banks,  jointly.  Since  the  investments  of  these  banks 
necessarily  consist  primarily  of  real-estate  mortgages  and  since, 
for  the  system  as  a  whole,  these  mortgages  are  drawn  from 
every  part  of  the  country,  it  will  be  seen  that  the  risks  of  the 
Federal  Land  bank  system  are  very  widely  distributed.  The 
law  also  provides  that  of  the  capital  of  the  Federal  Land  banks 
for  which  stock  is  outstanding  in  the  name  of  farm  loan  asso- 
ciations, 25  per  cent  must  be  held  as  quick  assets,  in  the  form 
of  cash  in  vault,  deposits  in  member  banks  of  the  Federal 
Reserve  System,  or  in  readily  marketable  securities  approved 
by  the  Federal  Farm  Loan  Board.  Of  these,  not  less  than  5 
per  cent  must  be  United  States  government  bonds.  Each 
Federal  Land  bank — given  conservative  management  in 
conformity  with  the  law — is  therefore  practically  certain  to  be 
in  a  position  to  meet  its  obligations  as  they  mature.  Certainly 
there  would  appear  to  be  little  chance  that  the  system  as  a 
whole  would  not  be  able  to  meet  its  obligations  in  fulL 

'  It  should  be  observed,  however,  that  while  the  theory  has  always 
been  that  provision  should  be  made  for  the  liquidation  of  fixed-capital 
loans  when  they  mature,  it  has  been  a  very  common  practice,  notably  in 
the  transportation  industry,  for  the  fixed-capital  indebtedness  to  be  renewed 
rather  than  paid.  Indeed,  it  can  almost  be  said  that  the  tendency  is  for 
the  fixed-capital  indebtedness  of  corporations  gradually  to  increase  rather 
than  decrease  in  amount  as  the  &ge  of  the  corporation  increases. 


RAISING  CAPITAL  FOR  AGRICULTURE  681 

The  maximum  interest  rates  that  may  be  charged  by  any 
Federal  Land  bank  is  6  per  cent.  It  is  also  provided  that  in  no 
event  shall  the  rate  charged  to  borrowers  exceed  by  more  than 
I  per  cent  the  rate  of  interest  on  the  bonds  issued  by  the  banks 
themselves.  That  is  to  say,  if  the  Federal  Land  bank  should 
sell  bonds  bearing  a  rate  of  4  per  cent,  it  could  not  charge  the 
farm  borrowers  more  than  5  per  cent.  It  is  important  to  note 
in  this  connection  that  principal  and  interest  are  expressly 
exempted  from  all  federal,  state,  and  local  taxation."^  Legal 
fees  and  recording  charges  are  also  paid  by  the  borrower;  but 
they  are  much  less  in  amount  than  under  the  old  system  of 
unregulated  private  lending. 

When  the  farm  loan  system  began  operations  the  bonds 
bore  an  interest  rate  of  4I  per  cent,  the  farmer  paying  5  per  cent. 
The  rise  in  interest  rates  during  the  war,  however,  made  it 
necessary  to  raise  the  rates  to  5I  per  cent,  with  the  farmer 
paying  6  per  cent,  leaving,  as  before,  one-half  of  one  per  cent 
to  cover  expenses  incurred  by  the  Federal  Farm  Loan  banks. 
At  tliiR  figure  the  farmers  were  enabled  to  borrow  at  lower  rates 
than  could  even  high-grade  industrial,  pubUc-utility,  and  other 
business  enterprises. 

5.  The  Joint  Stock  Land  banks.  These  institutions,  author- 
ized for  the  purpose  of  placing  the  private  mortgage  busi- 
ness upon  a  more  efficient  basis,  constitute  an  essential 
part  of  the  new  system  of  agricultural  finance.  Their  position 
in  the  agricultural-credit  structure  is  analogous  to  that  of  the 
Federal  Land  banks,  although,  as  the  chart  on  page  650  indi- 
cates, their  loans  are  not  as  a  rule  made  through  the  National 
Farm  Loan  associations.  In  organization  they  differ  from  the 
Federal  Land  banks  only  in  detail.  There  must  be  at  least  ten 
incorporators,  and  the  government  may  not  be  a  stock  sub- 
scriber. The  minimum  capital  required  is  $250,000,  one-half 
of  which  must  be  paid  up  before  beginning  business,  and  the 
rest  before  any  bonds  may  be  issued.  Instead  of  a  board  of 
nine  appointed  and  elected  directors,  they  have  a  board  of  their 

'This  fact  has  given  rise  to  bitter  controversy.  See  below,  pp. 
688-90. 


682  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

own  choice,  not  less  than  five  in  number.  The  size  of  the  loan 
granted  to  any  one  person  and  the  purposes  for  which  the  loan 
may  be  made,  are  left  to  the  discretion  of  the  Joint  Stock  bank. 
The  total  amount  of  bonds  that  may  be  issued  is  restricted  to 
fifteen  times  the  amount  of  the  capital  stock  of  the  issuing  bank, 
as  compared  with  twenty  times  in  the  case  of  the  Federal  Land 
banks. 

Like  the  Federal  Farm  Loan  bonds,  the  Joint  Stock  Land 
bank  bonds  must  be  secured  by  first  mortgages  on  land  and 
improvements,  the  margin  of  security  being  identical  in  both 
t)^es  of  bonds.  The  mortgages  back  of  the  Joint  Stock  Land 
bank  bonds  must  be  deposited  in  trust  with  the  Federal  Farm 
Loan  Registrar;^  and  the  loans  must  be  paid  on  the  amortization 
plan.  The  main  difference  between  the  two  types  of  securities 
hes  in  the  fact  that  the  Joint  Stock  Land  bank  bonds  are  an 
obligation  only  of  the  issuing  institution,  whereas  the  Federal 
Farm  Loan  bonds,  as  already  seen,  are  the  joint  and  several 
obligations  of  the  twelve  Federal  Land  banks. 

State  governments  have  also  been  interested  in  rural  credit 
legislation.  During  the  past  few  years  some  fifteen  states  have 
enacted  laws  designed  to  improve  agricultural  credit  facilities. 
In  general,  the  state  laws  are  designed  to  make  available  for 
agricultural  purposes  the  cash  and  credit  of  the  state  through 
the  creation  of  land  banks,  the  stock  of  which  is  owned  by  loan 
associations.  These  loan  associations,  which  are  called  by 
various  names,  are  co-operative  in  their  nature;  they  receive 
appUcations  from  their  members  for  loans,  grant  the  loans, 
execute  the  mortgages  and  deposit  them  with  the  land  bank. 
The  land  bank  deposits  the  collective  mortgages  with  the  state 
comptroller  and  issues  against  them  bonds  which  bear  a  lower 
rate  of  interest  than  does  the  collateral.  These  bonds  are  legal 
as  investments  for  savings  banks  and  trust  funds.    As  compared 

'  Incidentally,  the  bonds  are  engraved  by  the  Treasury  Department, 
as  are  the  Farm  Loan  bonds;  but  they  must  be  readily  distinguishable  in 
form  and  color  from  those  issued  by  the  Federal  Land  banks. 


RAISING  CAPITAL  FOR  AGRICULTURE  683 

with  the  Federal  Farm  Loan  System,  however,  the  significance 
of  these  state  rural  credit  institutions  is  not  great. 

The  Federal  Farm  Loan  System  has  had  a  substantial  growth. 
On  November  30,  1919,  there  were  3,890  associations  in  actual 
operation  with  an  average  number  of  members  of  27^.  The 
total  volume  of  loans  was  $282,007,781  giving  an  average  per 
association  of  $72,495.  The  number  of  associations  in  1920 
has  been  dechning,  in  part  because  there  is  already  in  excess 
of  one  for  every  county  in  the  United  States,  and  in  part  because 
there  is  a  tendency  toward  consoUdation  of  smaller  associations. 
The  attack  that  has  been  made  in  the  courts  upon  the  con- 
stitutionality of  the  rural-credit  law  has  also  deterred  the 
formation  of  new  loan  associations.*  Although  they  have 
been  in  operation  only  about  three  years,  the  Federal  Land 
banks  have  increased  their  capitalization  from  $9,000,000 
to  $20,000,000,  and  several  of  them  have  been  able  to  pay 
dividends  after  meeting  all  expenses  of  organization  and 
operation  and  setting  aside  substantial  sums  for  the  reserve 
accounts. 

It  is  interesting  to  observe,  however,  that  during  the  first 
year  of  its  history  the  Federal  Farm  Loan  System  experienced 
serious  financial  diflSculties  requiring  government  aid.  The 
4I  per  cent  tax-exempt  bonds  could  not  be  marketed,  and, 
as  a  means  of  avoiding  a  financial  collapse  of  the  system, 
a  request  was  made  for  a  Congressional  appropriation  of 
$200,000,000,  the  plea  being  effectively  made  that  agriculture 
would  otherwise  be  seriously  handicapped  in  its  efforts  to 
increase  food  production,  so  vitally  necessary  to  the  successful 
prosecution  of  the  war.  Somewhat  reluctantly  Congress 
authorized  the  appropriation;  and  imder  it  the  Secretary  of 
the  Treasury  has  purchased  $136,000,000  of  Farm  Loan  bonds 
from  the  Federal  Land  banks. 

There  follows  a  consolidated  financial  statement  of  the 
assets  and  liabilities  of  the  Federal  Land  banks  at  the  close  of 
business  October  31,  1919. 

*  See  pp.  688-90. 


6S4 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


CONSOLIDATED  STATEMENT  OF  FEDERAL  LAND  BANKS 

Assets 
Mortgage  loans    ....    $271,317,816.00 
Accrued   interest   on   mortgage 
loans 4,504,904.52 


Subtotal     . 
Less  amortization  payments 


$275,822,720.52 
2,326,278.86 


Net  mortgage  loans         .... 
United  States  Government  bonds  and  securities 
Accrued  interest  on  bonds  and  securities 
Other  accrued  interest 
Farm  loan  bonds  on  hand  (unsold)  . 
Cash  on  hand  and  in  banks 
Accounts  receivable     .... 
Delinquent  amortization  payments  . 

Banking  house 

Furniture  and  fixtures        ... 
Other  assets 


$273,496,441.66 
34,560,618.61 

439,435" 

2,405.40 

100,000.00 

6,299,417.55 

98,852.05 

152,256.18 

70,140.87 

178,184.10 

44,819.87 


Total $315,442,571.40 

Liabilities 


Capital  stock: 
United  States  government 
National  farm  loan  associa- 
tions      .... 
Borrowers  through  agents 
Individual  subscribers     . 


$    8,265,809.00 

13.536,782.50 
44,430.00 
47,235  00 


Total  capital  stock 

Reserve 

Farm  loan  bonds  authorized 

Bills  payable  (money  and  bonds  borrowed)    . 
Accounts  payable  (deferred  payments  on  loans  in 

process  of  closing) 

Reserved  for  interest  on  farm  loan  bonds       .       • 

Other  liabilities 

Undivided  profits. 


$21,894,256.50 
202,175.00 

285,600,000.00 
"5,075-78 

119,166.07 

6,407,274.7s 
361,327.87 

743,295 -43 


Total $315,442,571.40 


RAISING  CAPITAL  FOR  AGRICULTURE  685 

Memoranda 
Net  earnings  to  October  31,  1919     .       .       ,       .        $1,278,394.41 
Carried  to  reserve  account  to 

October  31,  1919  .  $202,175.00 

Dividends  paid  to  October  31, 

1919 332,923  98 


Undivided  profits  October  31,  1919  .... 

Capital   stock   originally   subscribed   by  United 

States  government 

Amount  of  government  stock  retired  to  date 
Capital  stock  held  by  United  States  government 
October  31,  1919 


535,098.98 
$743,295-43 

$8,892,130.00 
626,321 .00 

$8,265,809.00 


The  following  statement  sho"ws  the  amount  of  loans  applied 
for  and  granted  up  to  November  30,  1919,  segregated  by 
districts.* 

LOANS  OF  THE  FEDERAL  FARM  LOAN  SYSTEM 


District  Bank 

Applied  tok 

Loans  Closxd 

Na 

Amount 

No. 

Amount 

Springfield 

Baltimore 

Columbia 

Louisville 

New  Orleans 

St.  Louis 

St.  Paul 

8,030 

9,04s 
22,109 
16,469 
24,563 
20,715 
27,549 
14,720 
21,382 
26,529 
13,128 
31,919 

$25,953,774 
23,823,826 
48,313,298 

44,534,937 
45,732,800 
49,752,250 
77,702,704 
73,660,284 

56,454,309 
82,298,449 
43,793,201 
94,160,222 

3,834 
4,469 
6,990 
6,804 

13,283 
9,694 

13,720 
7,272 

10,293 

10,945 

4,805 

14,820 

$10,896,745 
11,433,800 
15,012,595 
19,936,700 
19,548,380 
22,217,250 
37,490,100 
36,855,390 
24,597,400 

Omaha 

"Wichita 

Houston 

31,408,401 

Berkeley 

Spokane 

15,000,800 
37,610,220 

Total 

236,158 

$666,179,374 

106,929 

$282,007,781 

Numerous  Joint  Stock  Land    banks  have  been  organized. 

Up  to  October  31,  19 19,  the  number  of  Joint  Stock  Land  banks 

*  Annual  Report  of  the  Federal  Farm  Loan  Board,  January  5, 1920,  p.  27. 


686         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

that  had  been  organized  was  twenty-six,  with  an  aggregate 
capital  stock  of  $7,812,050.  Mortgage  loans  stood  at 
$48,092,816  and  investments  in  United  States  government 
bonds  and  securities  at  $8,486,879.  The  growth  of  the  Joint 
Stock  banks  has  not  been  as  rapid  as  was  anticipated.  Of 
late,  moreover,  there  has  been  a  tendency  toward  consolidation 
of  existing  companies. 

IV.    SIGNIFICANT  RESULTS  OF  THE  FEDERAL 
FARM  LOAN  SYSTEM 

The  organization  of  the  Federal  Farm  Loan  System  has 
accomplished  three  important  results:  first,  it  has  equalized 
farm  interest  rates  throughout  the  country;  second,  it  has 
enabled  the  farmers  as  a  whole  to  borrow  at  lower  rates  than 
would  otherwise  have  been  possible;  and  third,  it  has  broadened 
the  scope  of  the  market  for  agricultural  securities.  The 
foregoing  description  of  the  system  furnishes  all  of  the  informa- 
tion necessary  for  understanding  how  each  of  these  results  has 
been  made  possible. 

The  equalization  of  interest  rates  has  been  accomplished 
by  means  of  the  provision  which  makes  Federal  Land  bank 
bonds  the  obligation  of  all  the  Land  banks,  jointly  and  severally. 
It  will  be  readily  seen  that  so  long  as  every  bond  is  the  obliga- 
tion of  all  the  banks,  the  investor,  resident  in  a  financial  center, 
has  no  good  reason  for  discriminating  against  the  bonds  of 
any  district,  however  remote  it  may  be;  from  his  viewpoint, 
the  bonds  of  each  district  are  exactly  as  good  as  those  of  every 
other  district.  It  should  be  noted,  however,  that  this  does  not 
apply  to  the  Joint  Stock  Land  bank  bonds;  for  they  are  the 
obligations  of  the  issuing  bank  only. 

The  lowering  of  farm  interest  rates  has  been  made  possible 
by  means  of  the  co-operative  borrowing  and  the  improved 
organization  of  credit  information  for  which  the  system  provides. 
Under  the  private  mortgage  system  the  primary  reason  for  the 
high  interest  rates  in  remote  agricultural  regions  is  the  lack  of 
reliable  information  on  the  part  of  the  lender  as  to  the  character 
of  the  borrower  and  the  adequacy  of  the  property  offered  as 


RAISING  CAPITAL  FOR  AGRICULTURE  687 

security.  Because  of  the  distance  involved  the  lender  has  to 
rely  upon  the  recommendation  of  the  local  farm-mortgage 
broker  or  upon  the  uncertain  appraisal  of  the  local  agent  of  a 
mortgage  company.'  Under  the  Federal  Farm  Loan  System 
the  lender  rehes  upon  the  appraisal  of  a  group  of  farmers 
organized  in  a  co-operative  farm  loan  association,  checked  by  an 
independent  appraisal  of  an  agent  of  the  Federal  Land  bank. 

Moreover,  as  we  have  aheady  seen,  the  payment  of  the 
loan  does  not  depend  upon  the  character  and  financial  standing 
of  a  single  individual  borrower;  for  the  loan  is  the  joint  obUga- 
tion  of  a  group  of  borrowers  and  of  the  twelve  Federal  Land 
banks.  Aside  from  the  risks  that  inhere  in  distance  and  the 
consequent  lack  of  reUable  information  there  is,  in  fact,  no  good 
reason  why  a  group  of  farmers,  say,  in  Texas,  borrowing  $25 
per  acre  on  land  valued  at  $50,  should  not  seciure  funds  at  as 
low  a  rate  of  interest  as  a  group  of  farmers  in  Illinois  borrowing 
$100  an  acre  on  land  valued  at  $200.  Under  the  Federal 
Farm  Loan  System  such  risks  have  been  eliminated. 

Through  the  substitution  of  bonds  of  small  denomination 
for  the  single  mortgage  of  relatively  large  size,  the  market  for 
agricultural  seciuities  has  been  broadened,  and  the  volume  of 
capital  available  for  agricultural  investment  consequently  in- 
creased. Individuals  with  small  as  well  as  with  large  resources 
may  now  invest  in  agricultural  securities  without  unduly 
concentrating  risks.  Moreover,  the  development  of  high-grade 
agricultural  bonds,  which  in  time  will  no  doubt  possess  a  high 
degree  of  marketability,  gives  greater  flexibility  to  the  system 
of  agricultural  finance  and  thus  serves  to  stimulate  agri- 
cultural investment.  By  means  of  the  machinery  provided 
by  the  rural  credit  legislation  the  farmers  of  the  country  have 
in  fact  been  placed  in  a  position  where  they  can  enter  the 
investment  market  on  better  than  even  terms  with  corporate 
industry.'  Indeed,  one  may  say  that  the  rural  credit  system 
has,  from  the  viewpoint  of  raising  capital,  "corporationized" 
agriculture. 

'  See  above,  p.  670. 

'  Put  see  criticism  on  pp.  689-90. 


688  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

V.    CRITICISMS  OF  THE  FEDERAL  FARM  LOAN 
SYSTEM 

There  have  been,  as  was  to  be  expected,  some  minor  criti- 
cisms of  certain  provisions  of  the  rural  credit  law  and  some 
of  its  administration  by  the  Federal  Farm  Loan  Board  and 
Land  bank  officials.  While  these  are  not  of  sufficient  impor- 
tance to  warrant  discussion  here,  there  have  been  two  criticisms 
of  such  significance  that  they  do  call  for  consideration.  The  first 
is  that  the  present  Farm  Loan  System  does  not  accomplish  the 
main  purpose  which  the  rural  credit  agitation  had  in  view, 
namely,  that  of  making  it  easy  for  farm  tenants  and  other 
landless  people  to  become  farm  owners.  The  second  is  that 
the  provisions  of  the  law  exempting  Federal  Land  banks  and 
Joint  Stock  Land  bank  bonds  from  taxation  is  perversive  in 
its  general  economic  and  social  effects. 

Those  who  believe  that  the  greatest  evil  of  the  American 
agricultural  system  is  the  rapid  increase  of  farm  tenancy 
naturally  hold  that  the  Federal  Farm  Loan  Act,  which  is 
primarily  designed  to  assist  existing  land  owners  in  making 
improvements  upon  their  lands  or  in  purchasing  additional 
acres,  has  missed  fire.  Granted  that  the  purpose  of  the  act 
was  to  decrease  tenancy,  this  criticism  is  undoubtedly  well 
founded;  for  the  present  law  certainly  does  not  render  essen- 
tially easier  the  acquisition  of  farm  land  by  those  who  are  at 
present  dispossessed.  On  the  other  hand,  there  are  those  who 
contend  that  the  present  act  was  never  intended  to  eliminate 
farm  tenancy,  and  that  this  evil  must  be  remedied  by  other 
means. 

The  second  criticism  of  the  system — that  against  the  tax 
exemption  provisions  of  the  law — would  never  have  arisen 
except  for  the  great  rise  in  interest  rates  during  the  war  and 
the  passage  of  progressive  income-tax  legislation.  As  matters 
now  stand,  however,  a  5^  per  cent  Federal  Farm  Loan  bond  is  a 
much  better  investment  for  people  with  large  incomes  than  is 
any  other  security.  It  will  be  seen  that,  since  the  heaviest 
taxes  are  levied  on  the  larger  incomes,  the  tax  exemption  of 
bonds  is  of  greatest  benefit  to  individuals  receiving  the  highest 


RAISING  CAPITAL  FOR  AGRICULTURE  689 

incomes.  "And  the  truth  is  that  these  bonds  are  being  pur- 
chased in  wholesale  quantities  by  men  of  very  large  means,  who 
thereby  escape  the  payment  of  a  substantial  portion  of  their 
federal  taxes.  The  case  is  put  by  one  writer  in  the  following 
words: 

An  Iowa  farmer  borrowing  $1,000  from  a  Federal  Land  bank 
pays  5I  per  cent  interest  or  $55.00  per  year.  The  Federal  Land 
bank  may  obtain  the  $1,000  to  loan  the  Iowa  farmer  by  selling 
$1,000  in  bonds  to  a  person  having  an  income  in  excess  of  $1,500,000 
per  year.  The  bond  is  exempt  from  all  taxes.  When  the  millionaire 
pays  his  income  tax  he  is  given  credit  to  the  extent  of  $33 .00  on  the 
$50.00  interest  received  on  the  thousand-dollar  bond  because  it  is 
exempt  from  income  tax.  Instead  of  paying  $33 .00  into  the  national 
treasury  he  retains  it  in  his  pocket  and  the  $33 .00  is  collected  from 
the  rest  of  the  American  tax-payers  to  fill  the  deficit  caused  by  the 
exemption.  The  loan  has  now  cost  the  farmer  $55.00  and  it  has 
cost  the  American  people  $33.00,  a  total  cost  of  $88.00.  When 
the  time  comes  for  payment  of  local  taxes,  the  very  wealthy  owner  of 
the  Federal  Land  bank  bond  declines  again  to  pay  taxes  on  the 
Federal  Land  bank  bond.  A  fair  and  moderate  estimate  of  the  tax 
which  he  evades  for  local,  state,  school,  and  municipal  purposes 
would  be  five  dollars.  This  five-dollar  deficit  in  the  local  treasury 
must  be  paid  by  his  neighbors  in  order  to  keep  up  local  and  state 
expenses.  The  direct  cost  of  the  Federal  Land  bank  loan  to  the 
country  at  large  is  $55.00  paid  by  the  farmer,  $33.00  exemption 
granted  to  bond-holder  on  income  tax,  $5.00  exemption  granted  to 
bond-holder  on  local,  state,  municipal,  and  school  tax,  a  total  cost  of 
$93.00  equaling  9.3  per  cent.  The  borrower  pays  $55.00  and  the 
American  people  at  large  pay  $38 .00. 

It  is  further  argued  not  only  that  the  tax  exemption  pro- 
vision plays  into  the  hands  of  the  rich  investor,  but  that  it  gives 
the  farmer  an  advantage  in  raising  capital  to  which  his  relative 
economic  position  does  not  entitle  him.  Why,  it  is  asked,  should 
the  farmer  be  permitted  to  borrow  at  5^  per  cent  at  a  time  when 
short-time  commercial  loans  of  the  most  approved  variety 
carry  rates  of  from  7  to  8  per  cent,  and  high-grade  railway 
and  industrial  corporation  securities  rates  of  from  8  to  9  per 
cent?  While  the  law  was  designed  to  develop  an  invest- 
ment mechanism  which  would  give  the  farm  borrower  an  even 


690  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

chance  with  other  borrowers  to  compete  for  capital  in  the 
investment  market,  it  was  not  intended  that  he  should  be 
given  an  arbitrary  differential  in  interest  rates.  It  is  merely 
the  accident  of  the  war  and  the  change  in  interest  rates  that 
has  brought  the  present  situation  about. 

The  controversy  over  the  tax  exemption  provision  has  been 
very  sharp  during  the  past  year,  the  constitutionality  of  the 
Federal  Farm  Loan  Act  having  been  challenged  in  the  courts 
and  bills  having  been  introduced  in  Congress  for  the  repeal 
of  the  law  and  the  complete  abolition  of  the  system.  Mean- 
while, pending  the  decision  of  the  courts  as  to  the  constitu- 
tionality of  the  Act,  the  Federal  Farm  Loan  System  has 
practically  ceased  to  function,  as  far  as  the  taking  on  of  new 
business  is  concerned. 

While  nearly  all  students  of  the  problem  are  agreed  that 
there  is  no  sound  reason  for  the  maintenance  of  the  tax-exemption 
provisions  of  the  law,  there  are  few  who  would  wish  to  see 
the  rural  credit  system  abolished,  for  it  is  believed  that  the 
evils  of  the  system  can  easily  be  remedied  by  Congressional 
amendments.  While  it  is  perhaps  too  early  to  make  a  final 
appraisal  of  the  Federal  Farm  Loan  System,  the  basic  principles 
underlying  the  law  are  generally  conceded  to  be  sound,  and  it 
would  be  a  very  great  misfortune  if  the  system,  as  amended, 
were  not  given  a  chance  to  prove  its  merits  under  conditions 
less  abnormal  and  fluctuating  than  those  that  have  obtained 
from  its  inauguration  to  the  present  time. 

EXERCISES  AND  QUESTIONS 

L      GENERAL  CONSmERATIONS 

1.  Compare  the  chart  on  page  650  with  those  on  pages  134  and  136, 
and  note  the  significant  differences  in  financial  structure  that 
have  developed. 

2.  In  how  many  different  ways  may  the  fixed  capital  used  in  agri- 
culture be  secured  ?    What  are  the  sources  of  working  capital  ? 

3.  In  what  ways  are  the  commercial  banks  related  to  the  farm- 
mortgage  business  ?    In  what  ways  the  trust  companies  ? 

4.  What  is  the  advantage  in  the  co-operative  credit  union  as  a 
means  of  securing  funds  for  agricultural  purposes  ? 


RAISING  CAPITAL  FOR  AGRICULTURE  691 

5.  When  a  bank  makes  loans  to  a  farmer  to  purchase  seed  and 
fertilizer,  and  to  pay  for  hired  help  during  the  growing  season, 
is  it  making  what  is  equivalent  to  a  commercial  loan  ?  What  is 
the  security  for  such  a  loan  ?    Is  any  mortgage  required  ? 

6.  If  a  farmer  borrows  from  a  bank  in  order  to  purchase  farm 
machinery,  such  as  plows,  harrows,  and  harvesting  machines, 
would  you  say  that  he  is  getting  an  investment  or  a  commercial 
loan?  How  long  a  time  should  such  loans  run?  Should  col- 
lateral be  required  ? 

7.  Are  the  risks  inherent  in  the  nature  of  the  industry  greater  or 
less  in  farming  than  in  manufacturing  or  mercantile  lines,  that 
is  to  say,  is  a  good  crop  more  or  less  certain  than  good  sales  by  a 
merchant  or  manufacturer  ? 

8.  Do  you  think  the  farmer  is  as  good  a  personal  risk  as  the  average 
merchant  or  manufacturer  ? 

9.  "If  you  would  sit  down  with  the  average  farmer  in  the  spring  and 
figure  out  the  actual  amount  necessary  to  carry  him  through 
imtil  fall,  and  say:  'Here,  Bill,  is  the  cash;  you  take  it  and  pay 
it  out  as  you  need  it, '  I  will  gamble  dollars  to  doughnuts  that  in 
sixty  days  he  would  have  spent  it  all,  and  90  per  cent  of  the 
amount  would  be  invested  in  things  he  never  intended  to  spend 
it  for,  and  he  wovdd  be  just  as  inconsiderate  in  paying  it  back 
promptly  when  due  as  he  was  in  spending  it,  and  that  is  just 
the  reason  Bill  has  to  pay  the  price  for  his  accommodation." 
Do  you  consider  this  a  fair  statement  ? 

10.  "I  think  that  the  farmer  gets  his  money  as  easily  and  as  cheaply 
as  the  commercial  man;  you  will  find  8  per  cent  country  is 
8  per  cent  country  for  everybody.  Bankers  have,  commercially 
speaking,  no  preference,  for  8  per  cent  looks  alike  to  them  no 
matter  who  pays  it,  as  long  as  they  really  get  it."  Do  you 
think  that  this  is  true  ? 

n.      TRADE  CREDIT 

11.  What  is  the  basic  objection  to  the  system  of  trade  credit  extended 
by  the  local  store  ? 

12.  Is  the  extension  of  credit  by  the  landlord  to  the  tenant  in  any  way 
less  objectionable  than  store  credit  ? 

13.  How  do  you  account  for  the  development  of  the  practice  whereby 
produce  dealers,  canning  factories,  etc.,  make  loans  to  agricultvu-al 
producers  ?    Do  you  approve  of  the  practice  ? 


692  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

14.  Criticize  the  system  of  credit  extension  practiced  by  the  manu- 
facturers of  farm  implements. 

15.  If  you  were  a  farmer  would  you  make  any  use  of  trade  credit  ? 
If  so,  why,  and  under  what  circvunstances  ? 

16.  Show  how  the  commercial  banks  are  related  to  the  extension  of 
trade  credit. 

m.     COMMERCIAL  BANK  LOANS 

17.  State  in  what  ways  the  problem  of  making  bank  loans  to  farmers 
differs  from  that  of  making  loans  to  mercantile  and  manufacturing 
customers  in  the  cities. 

18.  Why  are  agricultural  loans  so  frequently  renewed?  In  your 
judgment  is  this  an  objectionable  banking  practice?  Why,  or 
why  not  ? 

19.  On  the  whole,  do  you  think  the  working-capital  requirements  of 
agriculture  can  be  satisfactorily  met  through  securing  loans  from 
commercial  banks  ? 

20.  Which  would  you  prefer  to  have,  agricultural  loans  secured  by 
mortgages  on  real  estate,  payable  in  five  years,  or  the  unsecured 
promissory  notes  of  farmers  due  in  six  months,  but  indefinitely 
renewable  ? 

IV.      CATTLE  LOAN  COMPANIES 

21.  What  is  the  necessity  for  a  special  type  of  institution  for  financing 
the  cattle  industry  ? 

22.  Do  you  see  any  objection  to  the  afiiliation  of  a  cattle  loan  com- 
pany with  a  state  or  national  bank  ? 

23.  If  you  were  engaged  in  the  cattle  loan  business,  how  would  you 
classify  the  various  types  of  cattle  loans  from  the  standpoint  of 
desirability  ?    What  is  your  test  of  desirability  ? 

24.  What  is  the  purpose  of  the  "brand  sheet"  used  by  the  cattle 
loan  company  ?    Of  the  "form  statement "  ? 

25.  What  is  the  purpose  of  the  chattel  mortgage  on  the  cattle? 

26.  How  is  it  possible  in  the  case  of  feeder  cattle  for  a  loan  to  be 
made  with  safety  to  90  or  100  per  cent  of  the  value  of  the  cattle 
at  the  time  they  are  mortgaged  as  security  ? 

27.  Who  really  supplies  the  funds  used  by  cattle-growers  and-feeders  ? 

28.  Contrast  the  work  of  the  cattle  loan  company  with  that  of  the 
commercial  paper  house.  With  that  of  the  discount  or  conmier- 
cial  credit  company. 

20.  What  is  the  source  of  the  cattle  loan  company's  profits  ? 


RAISING  CAPITAL  FOR  AGRICULTURE  693 

30.  What  is  the  purpose  of  the  "certified  trust  receipt  of  chattel 
mortgage"  ? 

31.  State  in  your  own  words  the  economic  significance  of  the  cattle 
loan  company. 

V.      FARM  MORTGAGE  BORROWING 

32.  "Doubtless  you  all  remember  having  seen  a  picture  of  a  gnarled 
hand  hanging  over  an  humble  farm  cottage  as  a  horrid  s5mibol 
of  the  dead  pledge  or  mortgage.  I  believe  that  this  popular  idea 
of  the  mortgage  has  changed  during  the  past  generation.  The 
average  intelligent  progressive  farmer  now  regards  the  farm 
mortgage  as  a  blessing,  at  least  in  retrospect."    If  so,  why? 

Si-  Is  there  any  more  sympathy  due  a  farmer  who  mortgages  some 
land  as  a  means  of  adding  to  his  capital  than  is  due  a  railroad 
company  that  issues  bonds  and  gives  a  mortgage  on  the  railway 
property  ? 

34.  For  how  long  should  farm  mortgage  loans  run  as  a  rule  ?  Is 
there  any  justification  for  three-  and  five-year  loans,  which  have 
been  the  common  form  ? 

35.  "Every  community  should  be  financially  self-sufficient.  Those 
who  need  to  borrow  should  be  able  to  do  so  from  people  within 
the  commimity  who  have  funds  to  loan.  The  function  of  mort- 
gage banks  and  brokers  should  merely  be  to  bring  these  parties 

■  together."    Do  you  agree  with  this  principle?    Is  it  possible 
to  work  it  out  in  practice  ? 

36.  What  are  the  advantages  of  the  farm  mortgage  company  over 
the  individual  mortgage  broker:  (a)  from  the  viewpoint  of  the 
lender;  (6)  from  the  viewpoint  of  the  borrower  ? 

37.  What  would  you  say  is  the  chief  weakness  of  the  s}rstem  of 
lending  through  the  local  farm  mortgage  brokers  ?  through  mort- 
gage companies  ? 

38.  How  do  you  account  for  the  fact  that  farm  mortgage  banks  have 
not  been  subjected  to  government  regulation  as  have  commercial 
and  savings  institutions?  Do  you  think  they  ought  to  be 
subjected  to  governmental  supervision  ? 

39.  How  do  you  account  for  the  wide  variation  in  the  rates  on  farm 
mortgage  loans  that  existed  in  the  United  States  before  the 
adoption  of  the  Federal  Farm  Loan  Act  ? 

40.  What  items  other  than  interest  go  to  make  up  the  inclusive  costs 
of  mortgage  loans  ? 


694  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

41.  "The  difference  in  the  rate  of  interest  paid  by  the  Texas  farmers 
and  those  of  foreign  countries  in  twenty  years  would  macadamize 
every  road  in  Texas."  Does  this  indicate  that  the  farmers  of 
Texas  should  be  granted  loans  at  3  or  4  per  cent  ? 

42.  "Money  cannot  be  made  cheap  by  law  or  by  any  other  artificial 
means.  It  will  flow  naturally  into  the  channel  most  advantageous 
to  its  owners.  It  cannot,  therefore,  be  cheap  where  the  demand 
exceeds  the  supply.  Foreign  credit  systems  have  the  advantage 
that  money  is  normally  cheap,  the  resvdt  of  centuries  of  accumu- 
lations. The  systems  of  rural  credit  proposed  may  make  money 
cheaper  by  improving  the  security  on  which  it  is  loaned,  but  they 
cannot  perform  the  miracle  of  making  it  absolutely  cheap" 
(Editorial  in  National  Stockman  and  Farmer,  19 14).  Is  this 
good  economic  doctrine  ? 

43.  "The  whole  trouble  with  land  credit  conditions  today — and 
that  means  the  dearth  of  money,  the  rate  of  interest,  and  so  on — 
is  nothing  but  the  consequence  of  an  insufficiency  of  market  for 
the  security  which  the  farmer  offers,  and  the  reason  for  this 
insuflBciency  of  market  is  not  only  the  form  in  which  farm  loans 
are  usually  offered,  not  only  the  variety  of  laws  governing  the 
business,  but  also  the  variety  of  other  securities,  with  which 
the  American  market  is  clogged,  quite  in  contrast  to  the  European 
market,  which  is  comparatively  free  from  municipal  and  railroad 

.    and  also  some  classes  of  public-utility  securities. "    What  do  you 
think  of  this  contention  ? 

44.  "The  chief  difference  of  opinion  arises  over  whether  there  should 
be  special  aid  furnished  by  the  government.  There  seems  to  be 
no  emergency  which  requires  or  justifies  government  assistance 
to  the  farmers  directly  through  the  use  of  the  government's 
cash  or  the  government's  credit.  The  American  farmer  is 
sturdy,  independent,  and  self-reliant.  He  is  not  in  the  condition 
of  serfdom  or  semi-serfdom  in  which  were  some  of  the  European 
peoples  for  whom  government  aid  was  extended  in  some  form  or 
other  during  the  last  century.  As  a  matter  of  fact,  the  American 
farmers  are  more  prosperous  than  any  other  farming  class  in  the 
world.  As  a  class  they  are  certainly  as  prosperous  as  any  other 
great  section  of  the  people — as  prosperous  as  the  merchants,  the 
teachers,  the  clerks,  or  the  mechanics.  It  is  necessary  only  that 
the  government,  so  far  as  geographic  and  physical  conditions 
permit,  provide  machinery  for  the  benefit  of  the  agricultural 


RAISING  CAPITAL  FOR  AGRICULTURE  695 

classes  as  satisfactory  as  that  provided  for  any  other  class." 
Do  you  agree  with  this  general  principle  ? 

VI.      THE  FEDERAL  FARM   LOAN  SYSTEM 

45.  What  were  the  chief  arguments  for  the  establishment  of  the 
Federal  Farm  Loan  System  ? 

46.  Study  the  map  showing  the  Federal  Farm  Loan  districts.  Have 
you  any  criticisms  to  offer  as  to  the  boundary  lines  or  as  to  the 
cities  chosen  for  the  location  of  the  Federal  Land  banks  ? 

47.  Why  was  it  necessary  in  organizing  the  Federal  Farm  Loan 
System  to  provide  for  the  formation  of  Farm  Loan  associations  ? 

48.  What  is  the  purpose  of  the  Joint  Stock  Land  banks  ? 

49.  What  is  likely  to  be  the  ultimate  effect  of  the  Federal  Farm 
Loan   System   upon   the  private  mortgage  business?    Why? 

50.  Have  you  any  criticisms  to  make  of  the  machinery  devised  under 
the  Federal  Farm  Loan  System  for  negotiating  a  loan  and 
safeguarding  the  position  of  the  lender  ? 

51.  What  are  the  advantages  of  the  amortization  method  of  making 
payments:  (a),  to  the  purchaser  of  the  farm  mortgage  bonds; 
(b)  to  the  borrower  ? 

52.  What  is  the  reason  for  the  provision  of  the  Federal  Farm  Loan 
Act  that  amortization  payments  need  not  be  made  for  the  first 
five  years  of  the  loan  ? 

53.  Do  you  think  thirty-five  years  is,  as  a  rule,  the  most  desirable 
length  of  time  for  a  farm  mortgage  to  run  ? 

54.  Explain  how  the  Federal  Farm  Loan  System  makes  it  possible 
for  the  interest  rates  to  be  the  same  in  all  districts.  Does  this 
involve  what  amounts  to  a  tax  on  certain  districts  for  the  benefit 
of  others  ? 

55-  Do  you  agree  with  the  contention  often  advanced  that  there  was 
no  real  need  for  establishing  additional  agricultural  credit  machin- 
ery for  the  benefit  of  those  who  already  own  farms  ? 

56.  "The  increase  of  farm  tenancy  cannot  be  checked  by  merely 
providing  purchase  money  on  easy  terms  to  farm  tenants." 
Why,  or  why  not  ? 

57.  "In  the  light  of  the  changes  in  interest  rates  that  have  occurred 
during  the  war,  the  Federal  Farm  Loan  Act  has  placed  the 
farmer  in  a  much  better  borrowing  position  than  that  of  industrial 
and  commercial  interests.    This  is  not  fair  to  the  industrial 


696  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

and  commercial  borrowers  and  is  not  in  the  interest  of  the 
general  welfare. "    Why,  or  why  not  ? 

58.  Is  there  any  good  reason  for  continuing  the  exemption  of  farm 
mortgages  from  taxation  ? 

59.  Write  a  brief  statement  outlining:  (c)  the  principles  underljdng 
the  Federal  Farm  Loan  System;  and  (b)  the  effects  of  the  system 
upon  agricultural  development. 

REFERENCES  FOR  FURTHER  READING 

Hcrrick,  Myron  T.:  Rural  Credits. 

Moulton,  Harold  G.:  Principles  of  Money  and  Banking,  Part  II, 
chap.  ix. 

Nourse,  Edwin  G.:  Agricultural  Economics,  chaps,  xiii  and  xiv. 

Phillips,  Chester  A.:  Readings  in  Money  and  Banking,  chap,  xxvii. 

Pope,  Jesse  E.:  "Agricultural  Credit  in  the  United  States," 
Quarterly  Journal  of  Economics,  Vol.  XXVIII.  Also  printed  in 
Carver,  T.  N.:  Selected  Readings  in  Economics,  pp.  936-70. 

Putnam,  George  E.:   The  Land  Credit  Problem. 

Taylor,  Henry  C:   Agricultural  Economics,  chap.  xvL 

Annual  Reports  of  the  Federal  Farm  Loan  Board. 


CHAPTER  XXVIII 

CONSUMPTIVE  CREDIT  INSTITUTIONS 

From  the  point  of  view  of  the  uses  to  which  borrowed  funds 
are  devoted,  credit  was  classified  in  chapter  vii  under  the 
headings,  investment,  commercial,  and  consumptive  credit. 
In  the  preceding  chapters,  the  financial  structure  that  has 
been  developed  under  the  modern  capitalistic  system  in  connec- 
tion with  investment  and  commercial  credit  operations,  has 
been  discussed;  there  remain  to  be  considered  only  the  financial 
agencies  and  institutions  associated  with  the  making  of  loans 
for  non-productive  purposes.  Such  loans,  it  may  be  recalled, 
are  to  be  distinguished  from  investment  and  commercial  loans 
in  that  the  use  to  which  the  borrowed  funds  are  devoted  does 
not  provide  the  means  for  paying  the  loan  either  within  a 
short  or  a  long  period  of  time;  they  are  not  self-liquidating, 
but  must  be  paid  out  of  other  resources.  With  the  exception 
of  the  loans  contracted  through  the  building  and  loan  associa- 
tions, consimaptive  loans  are,  as  we  shall  see,  usually  of  very 
small  size;  and  they  are  contracted  by  persons  whose  credit 
standing  is  commonly  such  that  it  would  be  impossible  for 
them  to  secure  funds  from  the  financial  institutions  which 
we  have  been  considering  in  preceding  chapters. 

Consumptive  finance  has  been  relatively  neglected.  A  striking 
featiure  of  the  modern  financial  system  has  been  the  almost 
complete  absence — until  very  recent  times — of  "legitimate" 
financial  agencies  organized  for  the  purpose  of  extending  credit 
for  consumptive  purposes.  We  found  in  chapter  xix  that 
commercial  banks  sometimes  make  consumptive  loans  secured 
by  stocks  and  bonds  and  other  collateral;  and  we  have  else- 
where seen  that  a  vast  amount  of  trade  credit  is  extended  by 
retail  merchants  and  dealers  for  consumptive  requirements. 
But  the  lending  of  money  in  small  sums  for  consumptive 

697 


698  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

purposes  has  in  the  main  been  left  to  private  interests  which, 
acting  without  public  grant  of  power,  and  indeed  usually 
outside  the  pale  of  the  law,  have  ruthlessly  exploited  precisely 
those  classes  of  society  which  can  least  afford  to  be  exploited. 

The  explanation  of  the  lack  of  legitimate  financial  institu- 
tions in  the  field  of  consumptive  credit  is  apparently  the  age- 
old  prejudice  against  the  charging  of  high  interest  rates  to 
persons  in  distressed  circumstances.  Since  consumptive  loans 
are  not  devoted  to  uses  which  will  directly  provide  the  means 
of  repaying  the  loan,  and  since  the  borrower  for  consumptive 
purposes  is  commonly  in  reduced  circumstances,  such  loans 
necessarily  bear  a  much  higher  rate  of  interest  than  those 
made  for  industrial,  commercial,  or  agricultural  purposes. 
Hence  lending  for  consumptive  purposes  is  foredoomed  to 
unpopularity.  It  will  be  recalled,  moreover,  that  the  Bible 
condemns  all  interest  as  being  usury,  and  therefore  unjust. 
The  biblical  law  came  in  time  to  be  incorporated  into  the  civil 
codes  of  western  European  nations  and  it  was  not  until  the 
beginning  of  the  modern  era  that  any  interest  charge  was 
legal.  The  philosophy  underlying  this  prohibition  of  all 
interest  is  ascribable  either  to  a  sympathetic  regard  for  the 
poor  or  to  a  recognition  of  the  economic  impossibility  of  their 
paying  interest.  In  ancient  times  funds  were  borrowed  almost 
exclusively  for  consumptive  purposes — virtually  to  prevent 
starvation — ^and  such  loans  were  in  consequence  regarded  as 
in  the  nature  of  almsgiving.  To  exact  interest  from  a  poverty- 
stricken  class  seemed  to  violate  every  principle  of  common 
humanity. 

But  with  the  development  of  capitalistic  industry  and  the 
attendant  borrowing  of  funds  for  productive  purposes,  the 
charging  of  interest  appeared  in  a  very  different  light.  When 
a  borrower  devoted  the  funds  procured  to  productive  enter- 
prise, it  was  readily  seen  that  he  was  making  a  gainful  use  of 
the  loan  and  was  therefore  able  to  pay  back  the  principal  with 
a  bonus,  and  also  that  the  lender  was  foregoing  a  like  profitable 
employment  of  the  capital,  and  was  therefore  entitled  to  a 
recompense.     Gradually  the  charging  of  interest  on  such  loans 


CONSUMPTIVE  CREDIT  INSTITUTIONS  699 

was  universally  legalized;  but  even  to  the  present  day  we 
find  survivals  of  the  old  prejudice  in  the  usury  laws  of  the 
various  states,  which  prohibit  exorbitant  interest  rates,  that 
is,  rates  above  a  certain  prescribed  maximum — slightly  above 
the  normal  going  rates. 

The  existence  of  usury  laws  has  made  it  necessary  for 
any  financial  agency  which  desired  to  make  loans  for  con- 
sumptive purposes  to  charge  unlawful  rates  of  interest,  with 
the  result  that  the  risks  of  fine  and  imprisonment  involved 
contributed  to  still  higher  charges  than  would  otherwise  have 
prevailed.  Various  types  of  financial  institutions  have  been 
developed  through  private  initiative  for  the  extension  of  con- 
sumptive credit  to  individuals  in  need  of  financial  assistance. 
Some  of  them  are  of  long  standing,  among  the  earliest  forms 
of  financial  institutions,  indeed;  while  others  are  of  quite 
recent  development.  The  passage  of  remedial  loan  legislation 
by  a  number  of  American  states  diuing  recent  years  has, 
moreover,  done  much  to  place  the  business  of  consumptive 
lending  on  both  a  legitimate  and  a  substantial  basis.* 

I.    THE  BUSINESS  OF  PAWNBROKING 

One  of  the  chief  recourses  of  individuals  in  need  of  funds 
has  always  been  the  pawnbroker.  Indeed,  pawnbroking  appears 
to  be  the  oldest  form  of  banking  operation,  if  such  it  may  be 
called;  for  from  earliest  times  and  with  all  peoples  the  pledging 
of  personal  effects  as  security  for  advances  of  money  has  existed 
in  one  form  or  another.  At  the  present  time  pawnbroking 
plays  an  important  role  in  furnishing  consumptive  credit  in 
most  if  not  in  all  of  the  leading  cities  of  the  world.  Since 
the  business  of  pawnbroking  requires  a  dense  urban  population, 
it  has  had  its  greatest  development  in  the  United  States  during 
the  last  fifty  years. 

A  pawnbroker  is  defined  by  the  laws  of  the  District  of 
Columbia  as  "any  person,  corporation,  member  or  members 
of  a  corporation  or  firm  who  loan  money  on  deposits  or  pledge 
of  personal   property   or   other  valuable   things   other  than 

*  See  p.  706. 


70O  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

securities  or  printed  evidence  of  indebtedness  or  wha  deals  in 
the  purchasing  of  personal  property  or  other  valuable  things  on 
condition  of  selling  the  same  back  again  at  a  stipulated  price." 
The  second  part  of  this  definition,  relating  to  the  purchase  of 
property  to  be  resold  at  a  stipulated  price,  is  especially  impor- 
tant because  it  renders  it  impossible  for  individuals  to  resort 
to  this  means  of  avoiding  laws  which  are  directed  only  at  the 
loaning  oi  funds. 

The  pawnshop  makes  its  profits  by  loaning  its  own  capital. 
It  does  not  as  a  rule  borrow  from  banks.  The  earnings  are 
derived  either  from  an  interest  charge  on  the  money  loaned, 
or  from  a  special  charge  of  so  many  per  cent  a  month,  or  from 
a  combination  of  the  two  methods.  In  the  absence  of  restrictive 
legislation,  added  profits  are  also  often  derived  from  the  sale 
of  unredeemed  property  that  has  been  pledged. 

Practically  all  of  the  states  in  the  Union  have  passed  legis- 
lation of  one  sort  or  another  designed  to  control  the  pawn- 
broking  business;  and  the  municipalities  in  which  pawnbroking 
establishments  are  located  usually  have  ordinances  which 
supplement  the  state  legislation.  The  laws  of  the  different 
states  vary  so  widely  that  it  is  impossible  to  present  a  succinct 
summary  of  pawnbroking  legislation.  A  few  general  state- 
ments will,  however,  suffice  to  indicate  the  nature  of  the  regu- 
lation to  which  the  business  is  subjected. 

It  is  a  common  practice  for  either  the  state  or  municipal 
laws  to  require  the  taking  out  of  a  license;  and  in  a  few  states 
the  pawnbroker  is  required  to  give  a  bond  at  the  time  he  obtains 
his  license.  A  number  of  states  fix  the  interest  rates  and 
charges  which  may  be  levied;  and  many  state  laws  or  city 
ordinances  contain  provisions  governing  the  sale  of  unredeemed 
property.  The  better  laws  provide  that  a  certain  period  of 
time — usually  from  two  to  six  months — ^must  elapse  after  the 
period  fixed  for  the  redemption  of  the  pledge  before  the  effects 
can  be  sold.  Advertisement  of  the  sale  is  also  commonly 
required.  It  is  also  the  usual  practice  to  require  the  pawn- 
broker to  keep  a  register  giving  the  name  of  the  pawner,  the 
description  of  the  goods  pledged,  and  the  amount  of  money 


CONSUMPTIVE  CREDIT  INSTITUTIONS 


701 


loaned;  while  a  number  of  states  require,  in  addition,  the 
residence  of  the  pawner  and  the  rate  of  interest  charged.  A 
great  many  laws  do  not  make  any  provision  for  the  disposition 
of  a  surplus  above  the  amount  of  the  loan,  which  is  often 
received  from  the  sale  of  pledged  property.  Those  that  do 
make  provision  require  the  surplus  to  be  returned  to  the  owner 
of  the  goods. 

The  interest  rates  and  special  charges  vary  widely  in 
different  states  and  cities.  In  Baltimore,  for  example,  the 
interest  rate  is  6  per  cent  per  annum,  with  the  charges  2  per 
cent  per  month;  in  Chicago  the  interest  rate  is  3  per  cent  per 
month  with  charges  forbidden;  and  in  Philadelphia  the  interest 
is  6  per  cent  per  annmn,  with  charges  5  per  cent  per  month. 

Where  city  ordinances  or  state  laws  do  not  fix  the  duration 
of  the  loans,  the  general  rule  is  to  limit  it  for  thirty  days,  though 
renewals,  so  long  as  the  accrued  interest  is  paid,  are  usually 
granted  an  indefinite  number  of  times. 

The  following  table  shows  the  volume  and  the  nature  of  the 
business  of  the  pawnbroking  concerns  of  Chicago  for  one  month 
during  the  year  1898.* 

NATURE  OF  PAWNBROKING  LOANS 


Articles 

Number 

Amount  Loaned 

Average  Loan 

Gold  watches 

S,i6o 
2,980 
4,822 
2,276 
6,543 
356 
596 
1,724 

$40,242.35 

5,270.55 
34,141.10 
25,841.34 

11,344-45 

768.46 

1,225.50 

5,415-55 

$  7.80 
1-77 
7.08 

11-35 
1-73 
a.  16 
2.06 

Silver  watches . . . .  .^ 

Rings 

Jewelry 

Clothing 

Musical  instruments 

Firearms 

Miscellaneous 

314 

Total 

24,457 

$124,249.30 

$5.08 

Since  much  of  the  property  pledged  with  pawnbrokers 
consists  of  lost  or  stolen  goods,  the  regulation  of  the  pawnshops 
is  usually  vested  in  the  municipal  police.     The  most  common 

'  W.  R.  Patterson,  "Pawnbroking  in  Europe  and  the  United  States," 
Bulletin  of  the  Department  of  Labor,  March,  1899,  p.  274. 


702  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

plan  of  control  requires  the  pawnshops  to  make  daily  reports 
to  the  police  authorities,  and  the  police  to  make  daily  visita- 
tions of  all  the  pawnshops.  Indeed,  the  police  often  visit  the 
pawnbrokers  several  times  a  day;  for  it  is  their  duty  to  supply 
the  pawnshops  with  lists  of  stolen  or  lost  articles,  inspect  the 
pawnshop  books  and  pledges,  assure  themselves  that  the 
broker  has  kept  within  the  limits  of  the  law,  and  re<;over  any 
stolen  or  lost  articles  that  may  have  been  accepted  in  pawn. 
In  order  to  facilitate  the  work  of  the  police  in  identifying  those 
who  have  pledged  stolen  property,  a  few  states  require  a  minute 
personal  description  of  the  person  pledging  the  property.  And 
in  order  that  stolen  or  lost  property  may  be  traced,  some 
states  require  that  the  pawnbroker  may  not  disfigure  the 
property  pledged  during  the  period  that  it  is  subject  to  redemp- 
tion. Some  states,  moreover,  stipulate  that  no  article  may  be 
accepted  from  an  employee,  servant,  or  apprentice,  until  the 
pawnbroker  has  assurance  that  the  holder  is  the  rightful  owner, 
apparently  on  the  principle  that  such  a  person  is  assumed  to 
be  guilty  until  he  is  proved  innocent.  At  least  one  state  also 
stipulates  that  a  person  of  unsound  mind  shall  not  be  allowed 
to  place  articles  in  pawn,  while  another  prohibits  brokers 
from  receiving  pawns  from  a  person  appearing  to  be  intoxicated, 
from  a  notorious  thief,  or  from  an  individual  known  to  have  been 
convicted  of  larceny  or  burglary. 

In  recent  years  pawnshops  of  a  quasi-philanthropic  nature  have 
been  formed.  The  growth  of  state  and  municipal  legislation 
designed  to  regulate  the  pawnbroking  business  has  left  much 
to  be  desired.  There  is  not  only  great  diversity  in  the  legis- 
lative provisions,  some  of  them  being  practically  impotent; 
but  the  interest  rates  and  charges  are  as  a  rule  extremely  high. 
Accordingly,  an  attempt  has  been  made  in  recent  years  in  the 
United  States,  as  well  as  in  Europe,  to  place  the  making  of 
loans  secured  by  personal  property  upon  a  more  satisfactory 
basis  through  the  organization  of  pawnbroking  companies 
which  make  loans  secured  by  personal  property  with  as  small 
charges  to  the  borrower  as  is  consistent  with  safety  and  with 
the  earning  of  very  moderate  dividends  on  the  capital  stock. 


CONSUMPTIVE  CREDIT  INSTITUTIONS  703 

A  considerable  number  of  companies  of  this  type  have  been 
organized  in  various  cities  of  the  United  States.  They  usually 
are  distinguished  by  such  names  as  "collateral  loan  company," 
" workingmen's  loan  association,"  or  "provident  loan  society." 
These  institutions  are  organized  and  financed  by  men  of  high 
standing  in  the  community;  and  while  it  is  insisted  that  their 
purpose  is  in  no  sense  a  charitable  one,  it  is  nevertheless  a 
definite  part  of  the  plan  not  to  charge  all  that  the  traflBic  will 
bear,  but  to  make  the  institutions  merely  self-supporting.  One 
such  company  in  Chicago,  the  ofiicers  and  directors  of  which  are 
among  the  best  known  business  men  in  the  city,  has  now  been 
doing  business  for  more  than  twenty  years.  It  has  outstand- 
ing capital  stock  amounting  to  $800,000.  In  the  year  1919 
it  made  54,624  loans,  of  a  total  value  of  $2,083,576.50;  the 
net  earnings  were  $91,911,  of  which  $48,000  were  paid  out  in 
dividends,  a  rate  of  6  per  cent  on  the  capital  stock. 

While  legislation  on  the  subject  of  pawnbroking  has  been 
gradually  improving  and  while  the  plane  of  the  business  has 
been  substantially  raised  in  recent  years,  there  is  still  much 
room  for  improvement  in  the  conduct  of  the  business.  It 
would  seem,  however,  that  the  importance  of  the  business  of 
pawnbroking  will  be  substantially  lessened  in  the  future  in 
consequence  of  the  development  of  other  consumptive  credit 
agencies  to  be  described  below. 

II.    THE  LOAN  SHARKS 

Where  the  pawnbroker  advances  money  on  the  security  of 
property  left  with  the  pawnbroker  and  pledged  for  the  payment 
of  the  loan,  the  so-called  loan  shark  extends  credit  on  either 
the  unsecured  promissory  note  of  the  borrower,  or  upon  his 
note  secured  by  a  mortgage  on  household  furniture  left  in  the 
use  of  the  borrower,  or  by  an  assignment  of  wages  or  salary. 
Such  money  lenders,  whether  individuals,  firms,  incorporated 
associations,  or  stock  corporations,  have  a  permanent  loan 
capital  employed  solely  for  the  purpose  of  making  small 
loans,  usually  less  than  $300.    It  is  the  practice  to  arrange 


704  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

for   repayment   in   weekly  or   monthly  instalments,    usually 
averaging  ten  months. 

Loans  made  on  "plain  notes"  without  indorsement,  guar- 
anty, or  security  are  simple  character  loans.  While  the  risk 
involved  is  usually  fairly  high,  if  the  loan  is  small,  the  char- 
acter of  the  borrower  exceptionally  good,  and  his  employ- 
ment steady  and  remunerative,  such  loans  are  as  satisfactory 
as  any.  It  is  a  very  common  practice,  however,  to  require  the 
wife  to  join  in  the  obligation;  for  experience  has  shown  that 
confidential  loans  made  either  to  husband  or  wife  without 
knowledge  of  the  other,  carry  an  added  risk  of  loss  through 
failure  of  the  family  to  co-operate  and  economize  with  a  view 
to  repayment. 

Loans  that  are  secured  by  a  chattel  mortgage  on  property 
left  in  the  possession  of  the  borrower,  or  by  an  assignment  of 
the  borrower's  wages  or  salary,  are  not  so  much  superior  to 
the' unsecured  loans  as  one  might  suppose,  for  the  reason  that 
restrictive  laws  on  both  subjects  make  it  practically  impossible 
to  realize  upon  such  security  through  legal  process.  Moreover, 
since  the  loan  shark — who  necessarily  charges  usurious  rates 
of  interest — ^is  himself  outside  the  protection  of  the  law,  he  is 
not  in  a  position  to  command  the  aid  of  the  law  in  effecting 
collections.  Many  employers,  moreover,  refuse  to  recognize 
an  assignment  of  an  employee's  wages  or  salary. 

In  the  case  of  wage  and  salary  assignments  it  is  important 
to  note,  however,  that  many  employers  who  refuse  to  recognize 
wage  assignments  also  follow  the  practice  of  discharging 
employees  who  assign  their  incomes.  Where  this  is  the  case 
the  loan  shark  is  placed  in  a  pecuUar  position,  for  he  can  carry 
a  threat  to  the  borrower  that  the  employer  will  be  notified 
if  the  loan  is  riot  paid.  While  such  a  threat  is  of  no  value 
from  a  legal  point  of  view,  in  practice  it  is  a  very  effective 
means  of  collection. 

Because  of  the  lack  of  any  real  property  security  and 
because  of  the  illegality  of  their  own  operations,  the  loan  sharks 
have  found  it  necessary  to  employ  "roughhouse"  collection 
agents  and  "bawlersout"  to  intimidate  and  harass  the  hor- 


CONSUMPTIVE  CREDIT  INSTITUTIONS 


70s 


rowers  and  their  families  and  to  embarrass  them  with  their 
neighbors,  friends,  and  employers.  Interestingly  enough,  the 
loan  sharks  long  ago  discovered  that  women  are  the  most 
successful  agents  for  this  purpose. 

The  rates  charged  by  the  loan  sharks  vary  widely,  but 
they  are  always  ruinously  high.  The  minimum  appears  to  be 
10  per  cent  a  month,  while  20  per  cent  is  not  at  all  imusual. 
Many  individual  cases  have  been  noted,  moreover,  where  the 
rates  amounted  to  from  500  to  1,000  per  cent  a  year.  Since 
such  interest  rates  are  illegal,  the  charge  is  not  levied  as  an 
interest  rate,  the  most  common  method  employed  being  to 
add  50  per  dent  to  the  amount  of  the  loan  and  make  this  sum 
payable  without  interest  in  twelve  weekly  instalments.  Thus 
a  loan  of  $50  would  require  twelve  weekly  payments  of  $6 .  25 
each.  The  following  table  shows  the  charges  expressed  in 
terms  of  interest  fate  by  one  representative  salary  loan  company 
in  New  York.' 

INTEREST  RATES  ON  SALARY  LOANS 


Amount  OF  Cash 

Payments 

Total 

Amount 
Paid  by  the 
Borrower 

Amount 

Paid  IN 

Excess  of 

THE  Amount 

of  Cash 

Received 

Annual 

Interest 

Rate 

(Per 

Cent) 

Received 

BY  the 
Borrower 

Amount 

of 

Each 

When 
Due 

Number 

$2.00 
2.50 
2.45 
3.00 
4.00 
2.6s 
9.00 
4.50 

20.00 

Weekly 
Weekly 
Weekly 
Weekly 
Weekly 
Weekly 

Bi-Weekly 
Weekly 

Monthly 

12 
12 
16 
12 

13 
30 

6 

13 

3 

$24.00 
30.00 
39.20 
36.00 
48.00 
1        S300 
S4.00 
S4.00 
60.00 

$7.00 
8. so 
13.20 
10.00 
14.00 
19.00 
15.00 
14.00 
20.00 

339 
316 

308 
329 

286 

380 

300 

The  reasons  for  seeking  funds  from  the  loan  sharks  are 
sometimes  good  and  sometimes  not.  It  has  been  stated  by 
students  of  the  question  that  about  75  per  cent  of  the  indi- 
viduals who  borrow  from  the  loan  companies  are  men  with 
families  who  are  temporarily  in  need,  and  that  about  25  per 
cent  are  men  who  could  get  along  better  without  the  money, 
which    is   spent   in    gambling,   intemperance  and  vice.    For 

'  From  C.  W.  Wassam,  Salary  Loan  Business  in  New  York  City,  p.  36. 


7o6         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

temporary  need  of  funds,  sickness  or  death  in  the  home  is 
perhaps  the  most  common  cause.  The  payment  of  rentals 
in  advance,  moving  expenses,  life-insurance  premiums,  interest 
on  mortgages,  and  holiday  expenses,  are  among  the  frequent 
objects  for  which  the  money  is  secured.  It  has  been  estimated 
that  the  volume  of  small  loan  business  of  this  kind  in  the 
United  States  was  in  1918  about  $100,000,000,  the  average 
loan  being  in  the  neighborhood  of  $40. 

The  loan  shark  evil  is  now  being  rapidly  eliminated.  As  the 
result  of  an  extensive  campaign  conducted  by  the  Federation 
of  Remedial  Loan  Associations,  co-operating  with  the  Division 
of  Remedial  Loans  of  the  Russell  Sage  Foundation*  much  prog- 
ress has  been  made  during  the  last  few  years  in  improving  the 
status  of  the  small  loan  business.  The  improvement  has  been 
effected  in  two  ways;  first,  by  reform  loan  legislation  enacted 
by  various  states,  and  second  by  the  organization  of  new  forms 
of  loaning  companies  to  be  discussed  below.  As  a  result  the 
'  loan  shark  evil  is  now  almost  a  thing  of  the  past. 

When  legislation  governing  the  consumptive  loan  business 
has  been  enacted  by  a*  state  many  of  the  former  loan  sharks 
remain  in  business,  taking  out  state  licenses  and  henceforth 
conforming  their  practices  to  the  requirements  of  the  law. 
The  loan  sharks  were  admittedly  a  necessary  evil;  for  in  the 
absence  of  constructive  loan  legislation,  the  legitimate  loan 
agencies  rendered  a  service  to  the  community  that  was  indis- 
pensable. So  long  as  the  usury  laws  stood  upon  the  statute 
books  without  qualification,  it  was,  moreover,  impossible  for 
the  money  lenders  to  conform  to  the  law.  The  evil  lay  not 
so  much  with  the  loan  sharks  as  with  the  lack  of  remedial 
legislation. 

It  is  important  to  observe  in  this  connection,  that  the 
constructive  legislation  that  has  recently  been  passed,  with 
the  sanction  of  the  Remedial  Loan  Associations,  usually  legalizes 
an  interest  rate  of  3^  per  cent  a  month.  It  is  recognized  that 
costs  and  risks  attending  the  small  loan  business  are  such  that 
a  very  high  rate  is  necessary  in  order  to  attract  capital  into 
that  field,  and  that  the  inevitable  result  of  laws  which  unduly 


CONSUMPTIVE  CREDIT  INSTITUTIONS  707 

restrict  the  rate  of  interest  is  to  keep  reputable  concerns  out 
of  business  and  force  borrowers  to  secure  their  accommodations 
from  lenders  who  will  risk  violations  of  the  law  for  a  money 
consideration.  The  practical  choice  appears  to  lie  between 
licensed  loan  companies  charging  42  per  cent  a  year  and  ille- 
gitimate agencies  which  charge  several  hundred  per  cent. 

Under  the  operation  of  the  Small  Loans  Act  of  Illinois  in 
the  year  1919,  it  is  estimated  that  more  than  seven  million 
dollars  were  saved  to  borrowers  in  Chicago  alone.  Nearly  two 
hundred  sharks  were  driven  out  of  business;  and  the  new 
licensed  lenders  accommodated  nearly  45,000  small  tradesmen, 
laboring  men,  teachers  and  men  on  salaries. 

While  a  majority  of  the  states  now  have  laws  requiring 
the  licensing  of  money  lenders  and  many  others  have  laws 
regulating  the  making  of  small  loans,  there  is  still  much  to  be 
accomplished;  for,  in  the  words  of  the  Director  of  the  Legal 
Reform  Bureau  "many  of  these  laws  are  ill  considered,  inade- 
quate, crude,  impracticable,  and  ineffective."  A  uniform  small 
loan  bill  has  recently  been  evolved  by  the  interested  remedial 
agencies  and  it  is  hoped  that  this  may  in  good  season  be  adopted 
by  all  the  states.  Over  twenty  states  have,  in  fact,  passed  the 
measure.  In  brief,  this  law  makes  it  unlawful  without  a  state 
license  to  make  loans  to  the  value  of  $300  or  less  at  a  rate  of 
interest  in  excess  of  the  legal  bank  rate;  enumerates  what  the 
license  shall  contain;  fixes  the  annual  fee  at  $100;  requires  a 
bond  of  $1,000  with  sureties  to  the  state  for  ihs  use  of  any 
person  or  persons  who  may  have  cause  of  action  against  the 
obligor,  and  binds  the  lender  to  conform  to  and  abide  by  each 
and  every  provision  of  the  act. 

The  law  also  provides  for  the  revoking  of  the  license  by 
the  state  banking  department  which  is  charged  with  the  admin- 
istration of  the  act;  and  requires  notice  of  removal  of  place 
of  business  and  consent  of  the  banking  department  therefor. 
For  the  purpose  of  discovering  violations  of  the  act  the  state 
banking  department  may  at  any  time  and  as  often  as  may  be 
desired,  investigate  the  loans  and  business  of  every  licensee; 
and  for  that  purpose   shall  have  free  access  to  the  books, 


7o8         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

papers,  records  and  vaults  of  such  licensee.  It  shall  also  have 
authority  to  examine,  under  oath,  all  persons  whomsoever 
whose  testimony  may  be  required  relative  to  such  loans  or 
business. 

m.    THE  MORRIS  PLAN  BANK 

Among  the  interesting  institutions  developed  in  recent 
years  for  extending  credit  in  small  sums  for  consumptive 
requirements  is  the  so-called  Morris  plan  of  loaning  on  mere  ^ 
personal  responsibility.  This  plan,  after  being  tried  out  on  a 
minor  scale  in  the  South  for  about  fifteen  years,  has  been 
introduced  during  the  last  half-dozen  years  in  a  number  of 
the  larger  cities  of  the  country.  The  method  of  making  loans 
under  this  plan  is  as  follows:  the  appUcant  furnishes  references 
as  to  his  character  and  information  as  to  his  money  income. 
In  addition  he  is  required  to  have  at  least  two  indorsers  or 
co-makers  of  situation  and  income  at  least  as  good  as  his  own. 
For  each  $50  borrowed  he  agrees  to  pay  $1  a  week  for  fifty 
weeks.  The  interest  is,  however,  deducted  in  advance;  hence 
the  borrower  receives  only  $47.  In  case  he  fails  to  make  a 
payment  on  time  he  is  fined  five  cents  and  notified  of  his  delin- 
quency, while  if  he  gets  a  week  behind  his  co-makers  are  notified. 
They  may  be  relied  upon  to  see  that  he  catches  up  again  if 
he  can;  but  in  case  he  fails  to  do  so  the  indorsers  or  co-makers 
must  take  his  place  in  making  the  weekly  payments. 

IV.     CO-OPERATIVE  CREDIT  UNIONS 

While  the  function  of  the  co-operative  credit  union  is  to 
furnish  productive  as  well  as  consumptive  credit  to  its  members, 
it  may  most  conveniently  be  discussed  in  this  chapter.*  The 
explanation  of  the  development  of  these  organizations  is  usually 
assigned  to  the  lack  of  adequate  banking  facilities  in  many 
agricultural  conmiunities  and  to  the  need  for  better  credit 
facilities  among  the  small  tradesmen,  wage-earning  and  salary 

'  Co-operative  credit  organizations  among  farmers  were  briefly  discussed 

on  pp.  6152-53  above. 


CONSUMPTIVE  CREDIT  INSTITUTIONS  709 

folk  of  the  city.  Borrowers  of  small  sums,  whether  for  con- 
sumptive or  productive  requirements,  ordinarily  receive  little 
consideration  from  the  regular  banking  institutions. 

The  credit  union,  moreover,  is  not  merely  a  lending  insti- 
tution; it  is  also  an  agency  for  the  promotion  of  thrift  and 
business  responsibility  among  its  members.  To  quote  from 
some  of  its  leading  proponents. 

In  order  to  be  thrifty  many  a  man  requires  something  more  than 
agencies  to  receive  his  deposits  and  return  them  to  him,  when  needed, 
intact  with  interest:  he  requires  an  agency  which  will  make  its  hours 
of  business  conform  to  his  convenience,  which  is  conveniently  located, 
which  does  not  require  him  to  stand  in  line  for  a  long  time  awaiting 
his  turn  at  the  expense  of  his  lunch  hour  and  possibly  of  some  of  his 
employer's  time;  he  requires  an  agency  to  which  he  is  not  ashamed 
to  bring  a  dollar,  fifty  cents,  or  even  a  quarter;  an  agency  which  will 
constantly  remind  him  of  his  resolution  to  save  and  which  will  reward 
his  thrift  by  extending  credit  to  him  upon  easy  terms  of  repayment 
secured  solely  by  his  character  and  personal  worth — credit  which  will 
enable  him  to  effect  economies  in  purchasing  and  embarking  in 
productive  enterprises,  and  will  protect  him  from  the  userer.  By  its 
proximity  and  convenience  it  persuades  the  man  who  has  not  been 
reached  by  the  savings  bank  to  become  thrifty,  and  this  without 
interfering  with  the  growth  of  ordinary  banking  institutions;  instead, 
it  actually  increases  the  field  of  the  banks.  It  makes  the  accumidated 
capital  available  to  the  persons  who  assisted  in  its  accumulation. 
It  does  not  become  a  substitute  for  the  building  and  loan  asso- 
ciation or  the  remedial  loan  society;  instead,  it  becomes  a  com- 
plement of  these  agencies,  for  the  basis  ot  the  security  for  its  loans 
is  not  collateral  but  character.* 

As  indicated  at  the  end  of  the  foregoing  quotation,  the 
essential  basis  of  credit  in  the  co-operative  credit  union  is  the 
character  of  the  individual  borrower,  the  greatest  asset  of  an 
individual  being  considered  the  estimate  of  his  own  associates. 
The  advantage  of  the  credit  union  is  that  it  enables  those 
who  make  the  loan  to  have  an  intimate  knowledge  of  the  per- 
sonal habits  and  financial  and  domestic  situation  of  the  small 

'  Arthur  H.  Ham  and  Leonard  G.  Robinson,  A  Credit  Union  Primer 


7IO         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

borrower.  Being  composed  of  a  small  homogeneous  member 
ship,  mutually  acquainted,  such  loans  can  be  made  with  a 
minimum  of  risk  and  hence  at  a  relatively  low  rate  of  interest. 
Indeed,  because  of  the  close  association  of  the  membership, 
together  with  their  control  of  the  credit  union  itself,  the  rate 
of  interest  may  be  less  here  than  in  any  other  type  of  lending 
institution  engaged  in  the  extension  of  consumptive  credit. 

The  main  principles  and  most  approved  form  of  orgam'za- 
tion  of  credit  unions  may  be  outlined  as  follows:^ 

c)  Functions  of  a  Credit  Union 

1.  It  encourages  thrift  by  providing  a  safe,  convenient,  and 
attractive  medium  for  the  investment  of  the  savings  of  its  members 
through  the  purchase  of  shares  and  the  making  of'savings  deposits. 

2.  It  promotes  industry  by  enabling  its  members  to  borrow  for 
productive  and  other  beneficial  purposes. 

3.  It  eliminates  usury  by  providing  its  members,  when  in  urgent 
need,  with  a  source  of  credit  at  reasonable  cost,  which  they  could  not 
otherwise  obtain. 

4.  It  trains  its  members  in  business  methods  and  self-government, 
endows  them  with  a  sense  of  social  responsibility,  and  educates  them 
to  a  full  realization  of  the  value  of  co-operation. 

b)  Basic  Principles 

1.  Equality:  all  members  share  equally  in  privileges  and  ratably 
in  profits. 

2.  Democracy:  the  one-man-one-vote  principle  is  fundamental. 
Each  member  has  but  one  vote  irrespective  of  the  number  of  shares 
he  may  hold. 

c)  Where  and  by  Whom  Organized 

Any  number  of  persons  may  combine  to  organize  a  Credit  Union 
in  a  city,  town,  or  rural  community.  In  states  that  have  Credit 
Union  legislation  a  certain  number  of  the  incorporators  must  be 
citizens  of  the  United  States  and  of  the  state.  Where  a  Credit 
Union  is  organized  as  an  unincorporated  or  voluntary  association 
this  is  not  necessary. 

'  Adapted  from  Arthur  H.  Ham  and  Leonard  G.  Robinson,  ibid. 


CONSUMPTIVE  CREDIT  INSTITUTIONS  711 

d)  Basis  of  Membership 
The  basis  of  membership  in  a  Credit  Union  must  be  some  com- 
mon bond  or  community  of  interest.  This  may  take  a  number  of 
forms.  It  may  be  a  neighborhood.  It  may  be  common  occupation, 
employment  by  the  same  establishment,  or  membership  in  the 
same  church,  club,  lodge,  labor  union,  or  other  organization.  In 
rural  communities  the  church,  parish,  school  district,  or  local  grange 
furnishes  a  satisfactory  foundation  for  membership. 

e)  Qualifications  for  Membership 

1.  Identification  with  the  basic  imit  upon  which  the  Credit  Union 
is  fotmded — the  church,  the  club,  the  business  establishment,  etc. 

2.  Good  moral  character  and  a  reputation  for  honesty,  sobriety, 
and  industry. 

/)  Capital  Requirements 

1.  Capital  consists  of  payments  of  members  for  shares  and  of 
unpaid  dividends  credited  thereon. 

2.  There  should  be  no  hmit  to  total  number  of  shares. 

3.  Limitation  upon  number  of  shares  held  by  one  person  is  wise. 

4.  Par  value  of  $5.00  is  desirable. 

g)  Funds  in  Addition  io  Capital 

A  Credit  Union  may  accept  the  savings  deposits  of  its  members, 
and  may  borrow  from  members  and  others. 

Interest  on  savings  deposits  should  not  be  more  than  i  per  cent 
in  excess  of  savings  bank  rates  in  the  community. 

Borrowing  by  the  Union  is  merely  an  emergency  measure  and 
should  be  employed  only  when  absolutely  necessary  to  meet  the 
credit  demands  of  its  members. 

h)  Employment  of  Funds 
Except  for  the  Guaranty  Fund,  which  the  law  may  require  to  be 
invested  in  a  particular  manner,  the  fimds  of  a  Credit  Union  are 
primarily  to  be  used  for  the  purpose  of  making  loans  to  members. 
Surplus  funds  should  be  deposited  in  banks  or  invested  in  prime 
securities. 

i)  Who  May  Borrow 

All  members  in  good  standing,  except  the  Board  of  Directors, 
ofl&cers,  and  members  of  the  Credit  Committee  and  Sup)ervisory 
Committee. 


712         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

j)  Purposes  for  Which  Loans  May  Be  Granted 

It  is  essential  that  a  Credit  UnioH  should  loan  only  for  pro- 
ductive purposes,  purposes  that  will  effect  a  saving,  supply  an  xirgent 
need,  or  that  will  otherwise  prove  of  benefit  to  the  borrower. 

k)  Rate  of  Interest  on  Loans 

As  a  matter  of  principle  the  interest  charged  on  loans  should  be 
no  greater  than  is  required  to  pay  the  operating  cost,  a  moderate 
rate  of  interest  on  deposits,  to  provide  for  a  reasonable  reserve  or 
guaranty  fund,  and  to  pay  a  moderate  dividend  on  shares.  It  is 
well  to  fix  the  maximum  interest  rate  in  the  By-Laws.  This  rate 
should  as  nearly  as  possible  approximate  the  banking  rate  of  interest. 
(In  New  York  the  maximum  rate  of  interest  that  a  Credit  Union 
may  charge  is  12  per  cent  per  annum.)  Care  should  be  taken  that 
the  total  charges  upon  loans  do  not  exceed  the  maximum  allowed 
by  law. 

/)  Duration  of  Loans 

The  By-Laws  may  fix  a  general  maximum  but  the  time  of  indi- 
vidual loans  should  be  fixed  by  the  Credit  Committee  with  due  regard 
for  the  nature  of  the  employment  in  which  the  members  are  engaged, 
their  abiHty  to  repay,  and  the  objects  for  which  loans  are  made. 
A  maximum  of  one  year  should  be  suflicient,  even  though  it  may  be 
necessary  at  the  expiration  of  that  time  to  renew  a  portion  of  the  loan. 

Loans  should  be  repaid  in  weekly  or  monthly  instalments  or  in  a 
single  sum.  This  is  to  be  determined  in  each  instance  by  the  Credit 
Committee. 

m)  Security  for  Loans 

Ordinarily  the  security  that  a  Credit  Union  demands  for  loans  is 
the  promissory  note  of  the  borrower  with  one  or  more  endorsements, 
supplemented  by  a  lien  upon  the  borrower's  shares  and  deposits  in 
the  Credit  Union.  The  requirement  of  endorsements  may  be  waived 
in  some  cases  if  the  loan  is  for  a  small  amoimt.  Large  loans  may 
also  be  made  to  members  upon  the  security  of  a  mortgage  on  real  or 
personal  prop>erty;  but  unless  the  Credit  Union  has  an  abundance 
of  funds,  preference  should  be  given  to  the  smaller  loans. 

As  a  rule  members  only  should  be  accepted  as  endorsers.  In 
exceptional  cases  non-members  may  be  permitted  to  endorse  for 
members.    In  either  case  the  endorsers  must  be  acceptable  to  the 


CONSUMPTIVE  CREDIT  INSTITUTIONS  7^3 

Credit  Committee.  The  Credit  Committee  may,  if  it  deems  it 
necessary,  require  additional  security  upon  any  loan  in  the  form  of 
additional  endorsements,  a  mortgage,  or  other  collateral. 

Credit  unionism  has  been  extensively  developed  in  foreign 
countries.  Originating  in  Germany  about  the  middle  of  the 
last  century,  in  the  course  of  its  development  credit  unionism 
has  assumed  two  different  forms  known,  after  their  respective 
founders,  as  the  Raiffeisen  and  Schulze-Delitzsch  systems.  One 
or  the  other  of  these  systems— the  difference  between  which 
need  not  concern  us  here — has  been  adopted  with  modifications 
in  most  of  the  leading  countries  of  the  world.  It  was  estimated 
that  at  the  outbreak  of  the  Great  War  there  were  in  the  world 
more  than  65,000  of  such  associations,  having  an  aggregate 
membership  of  fifteen  million  people  and  an  annual  business 
amounting  to  over  seven  billion  dollars. 

It  was  not  until  1909  that  credit  unions  were  given  legal 
recognition  in  the  United  States  by  the  enactment  in  that 
year  of  the  Massachusetts  Credit  Union  Law.'  Since  that 
time  a  number  of  states  have  passed  similar  legislation,  but 
on  the  whole  the  growth  of  such  institutions  has  not  been  as 
rapid  as  was  expected  by  their  advocates.  This  is  due  in  part 
to  the  lessened  need  for  small  loans  during  the  period  of  war 
prosperity  and  in  part  to  the  gradual  elimination  of  the  loan 
shark  and  the  introduction  of  licensed  money  lenders.  There 
is  also  reason  to  believe  that  just  as  co-operation  of  every  sort 
has  been  beset  with  peculiar  difficulties  in  the  United  States, 
so  the  co-operative  credit  union  has  found  here  a  relatively 
infertile  soil.  It  appears  certain,  however,  that  credit  unions 
have  come  to  stay  and  that  their  importance  will  steadily 
increase. 

Credit  unions  abroad  have  had  beneficent  social  results.  There 
appears  to  be  no  difference  of  opinion  as  to  the  social  benefits 
derived  from  the  development  of  credit  unions  in  foreign 
countries: 

It  has  regenerated  and  accelerated  agriculture,  commerce,  and 
industry.    It  has  stamped  out  usury  and  raised  millions  of  human 

'  See  p.  653  above. 


714         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

souls  from  the  depths  of  despair  to  lives  of  hopefiilness  and  service. 
It  has  supplanted  shiftlessness  by  industry;  improvidence  by  thrift; 
intemperance  by  sobriety;  selfishness  by  neighborliness;  individual 
effort  by  concerted  action — ^in  fact,  has  proved  to  be  one  of  the  most 
potent  moral,  educational,  and  social  forces  in  the  history  of  civiliza- 
tion and  in  the  enrichment  of  the  life  of  the  common  people.' 

It  is  also  agreed  that  the  history  of  co-operative  credit 
unions  has  shown  conclusively  the  desirability  of  basing  these 
institutions  on  the  principle  of  self-help,  rather  than  on  philan- 
thropy in  any  form;  and  that  the  organization  must  spring 
from  a  co-operative  desire  and  must  depend  upon  the  manage- 
ment of  its  own  members.  The  greatest  student  and  the  greatest 
exponent  of  co-operative  credit  institutions  concludes  that 
Every  dallying  with  greed,  every  yielding  to  the  spirit  of  patron- 
age, foreign  experience  has  shown,  adds  a  toe  of  clay  to  the  huge 
brazen  Colossus,  and  thereby  threatens  to  overthrow  it  in  spite  of 
its  size.  And  the  thing  must  grow  from  out  of  its  own  self,  from  the 
bottom  to  the  top.  Committees  and  boards  can  do  nothing.  Large 
schemes  worked  by  public  bodies  are  as  much  out  of  place.  The 
workingman  and  the  farmer  must  become  "the  instruments  of  their 
own  emancipation."  None  of  the  s)^tems  that  have  succeeded 
abroad  have  been  organized  from  above.  They  have  all  risen  from 
below,  built  up  by  local  associations  ....  which  have  studied  to 
keep  themselves  independent  of  outside  influence,  self-contained,  yet 
firmly  connected  among  themselves  by  a  bond  of  union.  Nowhere, 
moreover,  has  this  work  been  "good  fairy"  work.  Every  shilhng's 
worth  of  success  has  been  purchased  by  unremitting  application,  by 
economy,  gratuitous  labor  (so  far  as  gratuitous  labor  was  possible), 
zeal,  and  caution.  And  experience  has  shown  that  it  is  not  otherwise 
to  be  obtained.' 

V.    BUILDING  AND  LOAN  ASSOCIATIONS 

The  building  and  loan  association  is  the  oldest  form  of 
co-operative  credit  institution  in  the  United  States,  the  first 
one  having  been  organized  in  a  suburb  of  Philadelphia  in  183 1. 
These  institutions  differ  essentially  from  some  of  the  others 
discussed  in  this  chapter  in  that  they  are  designed  to  enable 

'  Arthur  H.  Ham  and  Leonard  G.  Robinson,  ibid. 
*  Henry  W.  Wolff,  Peoples'  Banks,  p.  a6o. 


CONSUMPTIVE  CREDIT  INSTITUTIONS  715 

individuals  to  acquire  permanent  homes  rather  than  evanescent 
consumptive  goods;  in  a  very  real  sense  they  are  a  form  of 
savings  institution  and  they  might  as  logically  have  been 
discussed  in  connection  with  investment  credit  institutions 
as  here.' 

In  the  course  of  their  evolution  the  building  and  loan 
associations  have  passed  through  several  phases,  a  brief  account 
of  which  will  best  serve  to  indicate  both  their  purpose  and  the 
nature  of  their  operations.  The  original  form  of  building  and 
loan  association  was  little  more  than  a  home  builders'  club, 
where  each  individual  paid  into  the  common  treasury  a  certain 
sum  of  money  each  month.  The  purpose  was  to  secure  enough 
members  so  that  a  moderate  monthly  payment  by  each  would 
aggregate  every  month  a  fund  sufficient  to  liuild  a  home  for 
one  of  the  members.  For  example,  if  there  were  one  hundred 
members  and  each  paid  into  the  association  twenty  dollars  per 
month,  every  month  one  member  could  begin  the  building 
of  his  home,  to  cost  two  thousand  dollars;  and  at  the  end  of' 
one  hundred  months  each  would  have  a  two  thousand  dollar 
home.  The  club  required  each  home  builder  to  give  a  mortgage 
on  the  home  as  security  in  case  the  member  failed  to  continue 
his  monthly  payments  after  receiving  a  loan  from  the  associa- 
tion. When  each  member  had  acquired  a  home,  the  associa- 
tion, having  accomplished  its  purpose,  was  dissolved. 

A  second  step  in  the  development  of  the  building  and 
loan  association  was  marked  by  the  introduction  of  shares, 
which  enabled  any  individual  who  wanted  to  build  a  better 
home  than  his  fellows  to  do  so  by  investing  more  money  each 
month  than  the  others.  In  the  foregoing  illustration,  if  an 
individual  invested  $20  per  month  instead  of  $10,  he  could 
build  a  $4,000  instead  of  a  $2,000  house. 

A  third  phase  was  the  development  of  the  depositing 
member.  A  depositing  member  is  one  who  joins  the  associa- 
tion, not  with  the  expectation  of  borrowing  funds  for  the 
purpose  of  acquiring  a  home,  but  merely  for  the  returns  which 

'  This  of  course  holds  true  only  in  less  degree  for  the  co-operative  credit 
unions  discussed  in  the  preceding  section. 


7i6         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

he  may  receive  from  the  investment  of  his  funds  in  the  asso- 
ciation. The  profits  of  the  association  were  derived  from  two 
sources:  (i)  the  payment  of  interest  on  the  money  advanced 
for  home  building  by  the  borrowers  thereof;  and  (2)  from 
the  system  of  premiums  and  fines  which  was  developed.  Each 
individual  who  borrowed  funds  for  home  building  was  at  first 
supposed  to  pay  interest  to  the  association  at  the  current  rate; 
but  so  many  members  often  wished  to  build  at  the  same  time 
that  the  practice  developed  of  making  the  award  to  the  one 
who  would  bid  the  highest  above  the  current  rate  of  interest. 
The  fines  were  levied  against  members  who  became  delinquent 
in  paying  their  dues.  Both  these  sources  of  income  have  at 
times  proved  very  fruitful.  It  should  be  added  here,  however, 
that  the  system  of  fines  and  premiums  gave  rise  to  various 
abuses  in  connection  with  their  administration,  and  they  are 
now  being  gradually  eliminated. 

The  depositing  member  has  played  a  very  important  part 
in  the  development  of  building  and  loan  associations.  In 
crowded  industrial  centers  where  the  demand  for  loans  from 
prospective  home  builders  has  usually  exceeded  the  ability 
of  the  ordinary  members  to  furnish  the  fimds,  the  depositing 
member  has  proved  of  great  assistance.  Since  the  depositor 
was  interested  only  as  an  investor,  however,  it  was  found 
necessary  to  extend  him  one  privilege  not  possessed  by  the 
ordinary  member — that  of  withdrawing  his  shares  at  any  time 
in  case  he  desired  to  use  his  funds  elsewhere. 

The  fourth  stage  in  the  evolution  of  the  loan  association 
was  featured  by  the  introduction  of  the  serial  plan.  The 
original  associations,  as  we  have  seen,  were  dissolved  or  ter- 
minated as  soon  as  each  borrowing  member  had  acquired  a 
home;  but  under  the  serial  plan  the  association  becomes 
virtually  a  perpetual  organization.  Under  this  plan  additional 
members  may  be  added  to  the  original  association  at  stated 
intervals,  say,  once  a  year,  each  new  group  of  members  con- 
stituting an  independent  series  which  terminates  when  all  the 
members  of  the  series  have  acquired  homes.  Thus  the  associa- 
tion lives  as  long  as  new  series  of  members  continue  to  be  added. 


CONSUMPTIVE  CREDIT  INSTITUTIONS  717 

A  BUILDING  AND  LOAN  ASSOCIATION  STATEMENT* 

CASH  RECEIPTS 

Cash  on  hand,  April  I,  1915    ....     $     167.48 


Instahnents  "A" 
Instahnents"B" 
Interest    . 
Premium 
Fines  .     .     .     . 
Loans  repaid. 
Expenses  (rents) 
Real  estate  contracts 


$9,528.34 

2,400.00 

3,074-32 

S17.38 

17.00 

2,750.00 

25.00 

1,201.52 


19,603.56 
Outstanding  orders .     .     ,     ,     .     .     .         3,166.80 


Total $22,937.84 

ASSETS 

Real  estate  loans  and  con- 
tracts     $162,809,42 

Stock  loans 55,325.00 

Tax  certificates  .     .     .     .  681,03 

Interest,  taxes,  etc.,  due  and 

accrued 2,218.29 

Real  estate  owned  by  Asso- 
ciation         628.14 

Office  furniture  ,     .     .     .  179.00 

Cash  on  hand     ....  2,184.22 


Total $224,025.10 

CASH  DISBURSEMENTS 

Outstanding  orders,  April  I,  1915.     .     ,      $  2,099.08 


Instalments  withdrawn. 

3,170.50 

Interest    

238.50 

Expenses 

858.04 

Real  estate  contracts    .     , 

137-50 

Matured  stock    .     .     .     . 

10,800.00 

Contingent  fund      .     .     . 

700.00 

18,654.54 

Cash  on  hand     .... 

2,184..  22 

Total      ...... 

*One  hundred  and  sixty -fifth  Quarterly  Statement  of  Peoples'  Building  and  Loan 
Association,  Chicago. 


7i8         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  final  step  was  the  introduction  of  the  so-called  per- 
manent or  Dayton  plan  which  originated  in  1870  in  Dayton, 
Ohio.  It  is  merely  a  modification  of  the  serial  plan,  the  dis- 
tinguishing feature  being  that  it  is  unnecessary  for  an  indi- 
vidual who  wishes  to  join  a  permanent  association  to  wait 
until  the  opening  of  a  new  series  of  membership;  he  may  take 
out  an  individual  membership  at  any  time  and  purchase  as 
many  shares  of  stock  as  he  may  desire.  Each  borrower  can 
also  pay  off  his  debt  as  fast  as  he  desires  and  retire  from  the 
association  at  his  own  convenience.  Both  the  permanent  and 
the  serial  plan  are  found  at  the  present  time. 

The  management  of  building  and  loan  associations  is  vested 
in  a  board  of  directors  chosen  by  the  members,  while  the 
routine  administrative  duties  sue  performed  by  elected  ofl&cials. 
The  association  makes  two  types  of  loans,  known  as  stock 
loans  and  real  estate  loans.  Stock  loans  are  secured  by  the 
individual's  shares  in  the  association,  the  loan  being  limited 
as  a  rule  to  85  per  cent,  or  less,  of  the  book  value  of  the  shares 
at  the  time  the  loan  is  made.  The  real  estate  loans  are  made 
to  members  on  the  security  of  mortgages  on  the  homes  to  be 
built,  or  purchased.  The  valuation  of  the  property  is  made 
by  the  board  of  directors  or  by  an  appraisal  committee  appointed 
by  the  directors. 

An  interesting  problem  of  management  has  always  been 
that  of  the  disposition  of  the  accumulated  property.  In  the 
early  associations  the  earnings  were  kept  in  a  common  fund 
and  were  not  disturbed  until  the  time  of  final  dissolution,  losses 
meanwhile  being  paid  out  of  the  accumulated  funds.  But 
with  the  development  of  the  depositing  members,  who  had  the 
privilege  of  withdrawing  before  the  dissolution  of  the  associa- 
tion, and  whose  interest  in  the  organization  was  solely  that  of 
an  investor,  it  became  necessary  to  apportion  the  profit  from 
time  to  time  as  dividend^.  At  present,  it  is  the  almost  universal 
rule  to  pay  dividends  semi-annually. 

The  growth  of  building  and  loan  associations  in  the  United 
States  has  easily  kept  pace  with  the  increase  in  population 
and  the  development  of  other  forms  of  financial  institutions. 


CONSUMPTIVE  CREDIT  INSTITUTIONS  719 

In  the  year  19 18  there  were  7,484  such  associations  in  this 
country,  having  a  total  membership  of  4,011,401  persons  and 
total  assets  of  $1,898,344,346.  While  the  Eastern  and  Central 
States  have  the  largest  number,  the  distribution,  in  proportion 
10  population,  is  fairly  uniform  throughout  the  country. 

The  building  and  loan  associations  have  filled  a  real  need 
in  our  financial  system.  The  economic  and  social  significance 
of  the  building  and  loan  association  is  stated,  somewhat  extrava- 
gantly, by  one  writer  in  the  following  language:  '"Thrift  is 
being  encouraged;  economy  is  being  taught;  good  citizenship 
is  being  developed;  communities  are  being  improved;  and 
it  may  be  doubted  if  banking  in  any  of  its  forms  or  co-operative 
effort  in  any  other  direction  has  in  it  so  much  of  the  promise 
of  social  regeneration  or  the  potency  of  true  progress." 
Certainly,  it  may  be  said  that  the  lack  of  investment  banking 
institutions  equipped  to  provide  funds  for  the  small  home 
builder,  left  a  crying  need  for  an  institution  such  as  the  building 
and  loan  association.  Moreover,  the  especial  convenience  and 
cheapness  of  the  association  method  of  acquiring  and  paying 
for  property  would  under  any  circumstances  make  it  an  insti- 
tution capable  of  rendering  very  great  service  in  promoting 
thrift  and  economic  service. 

QUESTIONS  FOR  DISCUSSIONS 

I.      GENERAL  CONSIDERATIONS 

1.  What  is  the  explanation  of  the  failure  of  the  regular  banking 
institutions  to  make  loans  for  consumptive  credit  purposes? 
Is  such  loaning  unprofitable  ? 

2.  Why  has  there  always  been  so  strong  a  prejudice  against  private 
money  lenders  ? 

3.  What  is  meant  by  usury  ?  Do  you  favor  the  abolition  of  usury 
laws? 

4.  Why  does  the  maximvun  interest  rate  that  may  be  charged  vary 
widely  in  different  states  ? 

n.    THE  "small  loan"  business 

5.  Why  has  the  pawnbroking  business  always  been  held  in  social 
disesteem  ?    Does  it  render  no  economic  service  ? 


720  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

6.  How  does  the  pawnbroker  avoid  the  usury  laws  ? 

7.  How  do  you  account  for  the  fact  that  the  charges  levied  by 
pawnbrokers  are  less  than  those  levied  by  the  loan  sharks  ? 

8.  Would  you  favor  the  abolition  of  the  pawnbroking  business  F 
If  not,  what  sort  of  regulation  would  you  require  ? 

g.  To  what  is  the  origin  of  the  loan  shark  attributable  ? 

10.  What  are  the  different  types  of  security  back  of  "small  loans"  ? 

11.  What  is  the  weakness  and  the  possible  strength  of  loans  secured 
by  assignments  of  wages  or  salaries  ? 

12.  "'Character'  loans  are  safe  only  among  a  stable  and  frugal 
population,  entirely  non-speculative,  and  steadily  engaged  in 
some  regular  avocation  which  the  people  thoroughly  understand 
and  which  they  expect  to  follow. "     Do  you  agree  ? 

13.  Under  the  imiform  Small  Loan  Law  a  rate  of  interest  of  3I  per 
cent  a  month  has  been  legalized.  Do  you  regaYd  this  as  legisla- 
tion designed  to  promote  the  welfare  of  the  masses  ? 

14.  Do  you  beUeve  that  philanthropic  or  semi-philanthropic  loans 
will  in  the  long  run  lead  to  the  most  desirable  results  ? 

15.  Do  you  consider  the  security  offered  under  the  Morris  plan  as 
reasonably  satisfactory  ? 

16.  What  rate  of  interest  is  charged  under  the  Morris  plan?  Note 
that  the  nominal  rate  does  not  tell  the  whole  story. 

m.      CO-OPERATIVE  CREDIT  UNIONS 

17.  In  what  ways  do  the  functions  of  credit  unions  differ  from  those  of 
the  private  lending  institutions  ? 

1 8.  What  is  the  point  to  having  a  club  or  other  organization  as  the 
basis  of  membership  ? 

19.  Do  you  believe  in  the  principle  of  one  man,  one  vote  ? 

20.  Why  is  it  important  to  make  the  par  value  of  shares  only  $5  ? 
To  limit  the  number  of  shares  held  by  one  person  ? 

21.  Does  it  seem  to  you  that  the  savings  feature  of  the  credit  union 
is  as  important  as  the  loaning  feature  ? 

22.  Why  should  not  the  ofl&cers  and  directors  be  permitted  to  borrow 
from  the  union  ? 

23.  Do  you  regard  the  security  for  loans  ample?  Is  it,  primarily, 
character  or  property  security  ? 

24.  Just  how  is  it  possible  for  credit  unions  to  make  loans  at  lower 
rates  than  private  loaning  agencies  ? 


CONSUMPTIVE  CREDIT  INSTITUTIONS  721 

25.  Which  do  you  regard  as  of  greater  importance — the  direct  or 
the  indirect  benefits  of  the  credit  union  ? 

26.  Is  there  any  reason  why  such  institutions  should  not  be  exten- 
sively developed  in  the  United  States  ? 

IV.      BUILDING  AND  LOAN  ASSOCIATIONS 

27.  "The  building  and  loan  association  is  a  co-operative  means  of 
effecting  savings. "     How  ? 

28.  "The  building  and  loan  association  is  both  a  source  of  loans  and 
a  place  where  money  may  be  invested  at  interest. "    How  ? 

29.  How  has  it  ordinarily  been  determined  which  member  of  the 
association  should  have  the  privilege  of  building  first  ?  Do  you 
think  this  is  a  good  principle?  What  is  the  objection  to  the 
system  of  premiums  ? 

30.  Do  you  regard  the  security  back  of  the  loan  made  by  the  loan 
association  as  ample  ? 

31.  What  is  the  advantage  of  the  serial  plan  of  organization  as 
compared  with  the  terminating  plan  ? 

32.  What  are  the  practical  advantages  of  the  permanent,  or  Dayton, 
plan  ?     Do  you  see  any  disadvantages  in  it  ? 

33.  How  does  the  building  and  loan  association  differ  from  the 
credit  union  in  its  purpose  and  method  of  organization  ?  Would 
you  say  that  it  is  a  true  co-operative  institution  ? 

34.  In  the  absence  of  the  building  and  loan  association  what  rate  of 
interest  would  the  man  of  small  means  probably  have  to  pay 
for  funds  used  in  the  purchase  of  a  home  ? 

35.  Not  all  home  building  is  effected  by  means  of  the  building  and 
loan  association.  What  are  the  other  means  of  securing  the 
funds  that  are  now  available  ? 


REFERENCES  FOR  FURTHER  READING 

Dexter,  Seymour:  Building  and  Loan  Associations. 

Ham,  Arthur  H.,  and  Robinson,  Leonard  G.:  A  Credit  Union 
Primer. 

Hodson,  Clarence:  Money  lenders,  License  Laws  and  the  Business 
of  Making  Small  Loans  (Legal  Reform  Bureau,  29  Cortlandt  St.,  N.Y.). 

Levine,  Samuel  W.:  The  Business  of  Pawnbroking;  A  Guide 
and  a  Dejeme. 


722  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

Moxilton,  Harold  G.:  Principles  of  Money  and  Banking,  Part  II, 
chap.  viii. 

Patterson,  W.  R.:  Pawnhroking  in  Europe  and  the  United  States 
(United  States  Department  of  Labor,  Bulletin  No.  2i,  March,  1899, 

PP-  173-310)- 

Wassam,  Clarence  H.:  The  Salary  Loan  Business  in  New  York 
City. 

Wolff,  Henry  W.:  Co-operative  Credit  for  the  United  States. 


CHAPTER  XXIX 

FINANCIAL  INTEGRATION 

The  desirability  of  specialization  by  financial  institutions 
has  long  been  emphasized  in  the  writings  of  both  economists 
and  practical  bankers  and  in  legislative  acts  and  court  decisions. 
Just,  as  specialization  became  the  dominant  characteristic  of 
industry  and  commerce  during  the  greater  part  of  the  nineteenth 
century,  so  specialization  in  the  field  of  finance  came  to  be 
regarded  as  in  the  natural  order  of  things.  A  few  brief  state- 
ments will  be  sufficient  to  indicate  the  prevailing  views  as  to 
what  constitute  the  "legitimate"  functions  of  the  different- 
types  of  financial  institutions  that  we  have  been  discussing  in 
the  preceding  chapters. 

In  the  writings  of  economists  and  practical  bankers  are 
found  repeated  statements  to  the  effect  that  the  business  of 
commercial  banking  is  merely  to  facilitate  commercial  trans- 
actions through  the  making  of  short-time  loans — to  manufacture 
credit  and  furnish  an  important  part  of  the  medium  of  exchange. 
Emphasis  is  also  very  commonly  placed  upon  the  relation  of 
commercial  banking  to  the  marketing  or  mercantile  process; 
indeed  the  term  "commercial"  bank  owes  its  origin  to  this 
emphasis — the  words  commercial  and  mercantile  being  used  as 
practically  synonymous  terms.  Banking  literature  and  legis- 
lation unite  in  condemning  the  making  by  commercial  banking 
institutions  of  long-time  loans  for  fixed  capital  purposes. 

Savings  banks,  on  the  other  hand,  are  in  theory  intended  to 
facilitate  only  the  raising  of  fixed  capital,  to  collect  the  httle 
rivulets  of  individual  savings  and  turn  them  over  in  larger 
amounts  for  investment  uses.  Investment  banks  similarly 
act  as  intermediaries  in  the  raising  of  funds  for  fixed  capital 
purposes.  Even  the  trust  company  was  originally  designed  to 
act  primarily  in  the  capacity  of  trustee,  its  banking  fimctions 

723 


724         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

being  limited,  at  best,  to  investment  operations  incidental  to 
the  employment  of  trust  funds. 

There  is  nowadays  relatively  little  specializaiion  by  financial 
insiittUions.  From  our  analysis  in  preceding  chapters,  we  have 
aheady  seen  that  in  practice  financial  specialization  is  far  from 
complete.  We  have  seen,  for  instance,  that  savings  banks  do  a 
considerable  volume  of  commercial  banking  business;  some 
of  them,  particularly  in  the  Middle  West,  are,  in  fact,  difficult 
to  distinguish  from  commmercial  banks,  since  they  handle  both 
commercial  and  savings  accounts  and  make  loans  for  com- 
mercial as  freely  as  for  investment  purposes.  Indeed,  a  large 
majority  of  all  savings  banks  make  loans  for  working  capital 
purposes — directly  to  customers  and  indirectly  through  the 
purchase  of  commercial  paper  and  acceptances  in  the  open 
market.^ 

We  have  seen  that  commercial  banks  do  not  now  confine 
their  loaning  operations  to  mercantile  establishments,  but 
extend  credit  to  all  classes  of  enterprise,  industrial  and  financial 
as  well  as  commercial;  we  have  seen  that  some  of  their  unse- 
cured loans  are  devoted  to  fixed  capital  purposes — this  being 
particularly  the  case  with  the  state  institutions,  and  we  have 
found  that  they  make  a  huge  voliune  of  loans  on  collateral,  a 
large  percentage  of  which  is  devoted  to  fixed  capital  purposes.' 
It  has  been  noted  that  commercial  banks  now  usually  have 
savings  departments  ;3  and  it  may  be  noted  that  many  of  them 
also  have  investment  banking  or  bond  departments.  Some  of 
the  largest  commercial  banks  of  the  great  financial  centers  are 
extensively  engaged  in  underwriting  activities,  while  many  of 
the  state  commercial  banks  are  actively  interested  in  the 
financing  of  urban  real  estate  operations,  particularly  the  con- 
struction of  apartment  buildings.  Investment  banks  nowadays 
frequently  have  commercial  banking  departments;  while  even 
the  commercial  paper  houses  have  in  some  instances,  at  least, 
broadened  the  scope  of  their  operations  to  include  underwriting 
and  bond  distribution.      Finally,  in  our  study  of  trust  com- 

'  See  chap,  xviii,  particularly  the  financial  statements  on  pp.  328 
and  333-34  above.     See  also  pp.  731-32  below. 

*  See  chap.  xxi.  »  See  pp.  334-35  above. 


FINANCIAL  INTEGRATION  725 

panics  we  have  seen  that  the  laws  now  permit  them  to  engage 
in  a  great  variety  of  financial  operations,  including  trustee- 
ship, agency,  suretyship,  and  both  investment  and  commercial 
banking.* 

In  a  general  way  it  is,  therefore,  already  clear  that  there  is 
in  fact  no  such  clean-cut  specialization  among  financial  insti- 
tutions as  has  been  commonly  supposed.  But  if  we  are  fully 
to  appreciate  the  extent  to  which  integration  has  been  carried 
out  in  the  financial  world  and  the  reasons  for  this  trend,  it  will 
be  necessary  to  study  the  development  of  the  trust  company 
as  a  type  of  financial  institution  and  to  indicate  the  effects  of 
this  development  upon  the  operations  of  commercial  banks. 

I.    CAUSES  OF  THE  GROWTH  OF  FINANCIAL 
INTEGRATION 

While  the  laws  of  most  states  did  not  in  the  early  days 
give  to  trust  companies  specific  power  to  engage  in  commercial 
banking  operations,  the  opportunity  to  increase  their  profits 
by  accepting  demand  deposits  and  making  short-time  loans 
was  so  enticing  that  these  institutions  gradually  assumed  the 
functions  of  discount  and  deposit.  This  of  course  brought 
them  into  direct  competition  with  national  and  state  commercial 
banks,  which  were  denied  the  power  to  engage  in  trust  company 
business;  and  for  a  generation  vigorous  opposition  was  waged 
by  the  commercial  banks  to  this  "unwarranted"  invasion  of 
their  sacred  field  of  enterprise.  It  was  contended,  moreover, 
that  this  broadening  of  the  scope  of  trust  company  operations 
was  as  dangerous  as  it  was  illegitimate.  Numerous  cases  came 
before  the  courts  and  at  first  the  decisions  supported  the  con- 
tention that  commercial  banking  was  not  a  legitimate  field  of 
trust  company  operation.  But  as  the  trust  companies  of 
various  states  continued  to  extend  the  commercial  side  of  their 
business,  the  state  courts  gradually  came  to  accept  the  move- 
ment as  inevitable." 

'  See  also  statement  on  p.  762  below. 

'  See  Tso  Hang  Mai,  The  Banking  Functions  of  Trust  Companies 
(a  Master's  thesis  of  the  University  of  Chicago),  1920. 


726 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


It  was  during  the  decade  of  the  eighties  that  the  trust 
companies  first  actively  engaged  in  the  commercial  banking 
business.  Flying  in  the  face  of  banking  theory  and  the  power- 
ful opposition  of  the  commercial  banks,  both  state  and  national, 
the  trust  companies  continued  to  expand  the  commercial  side 
of  their  business  and  to  grow  with  amazing  rapidity.  It  will  be 
seen  from  the  charts  on  pages  359-60  that  while  the  number  of 
trust  companies  is  still  much  smaller  than  the  number  of 
national  and  state  banks,  the  rate  of  increase  has  been  quite  as 
rapid,  more  rapid  indeed  than  that  of  the  national  banks;  and 
that  the  average  size  of  trust  companies  is  about  three  times 
that  of  national  and  twelve  times  that  of  state  banks.  The 
greater  number  of  national  and  state  banks,  particularly  of 
the  latter,  is  largely  attributable  to  the  fact  that  until  recently 
the  trust  company  has  found  a  remunerative  field  of  enterprise 
only  in  the  larger  cities — a  fact  which  is  also  the  explanation 
of  the  large  average  size  of  the  trust  company.  In  the  last  few 
years,  however,  the  number  of  trust  companies  has  been  rapidly 
increasing  in  the  smaller  cities. 

That  the  rapid  growth  of  the  trust  companies  has  not 
been  confined  to  the  investment  and  trust  features  of  the 
business  may  be  seen  from  the  following  statistics  of  deposits  in 
trust  companies,  and  in  state  and  national  banks  respectively 
in  the  year  1918:^ 


CHARACTER  OF  DEPOSITS  IN  COMMERCIAL  BANKS  AND 
TRUST  COMPANIES 

(In  millions  of  dollars) 


Trust  Companies 

State  Banks 

National  Banks 

Demand  deposits 

Time  deoosits 

$2,215 
1,523 
2,323 

$2,929 
2,098 
1,087 

$7,838 
2,344 

Not  classified* 

Total  deposits 

$5,971 

$6,114 

$10,182 

*Some  state  institutions  do  not  differentiate   in   their  reports  between  time  and 
demand  deposits. 

« Report  of  the  Comptroller  of  the  Currency,  H  (1918),  170,  794,  818. 


FINANCIAL  INTEGRATION 


727 


It  will  be  noted  that  the  deposits  of  trust  companies,  both 
demand  and  time,  compare  favorably  in  volume  with  those  of 
the  commercial  banks.  Quite  as  significant  in  indicating  the 
growing  similarity  of  commercial  banks  and  trust  companies 
are  the  comparative  figures  of  time '  deposits,  which  show 
conclusively  that  the  liabilities  of  commercial  banks  are  far 
from  being  exclusively  of  a  demand  nature. 

The  following  statistics  on  the  loans  of  the  various  types  of 
institutions  afford  further  evidence  of  the  same  trend:' 


CHARACTER    OF   LOANS    IN    COMMERCIAL    BANKS    AND 
TRUST  COMPANIES 


(In  millions  of  dollars) 


Trust 
Companies 

State 
Banks 

National 
Banks 

Loans   secured   by  farm  lands, 
and  other  real  estate 

$     556 

1,405 
2,378 

$     291 

403 
4,041 

$      185 

3,838 
5,918 

Loans  secured  by  collateral  other 
than  real  estate 

All  other  loans 

Total  loans  and  discounts. . 

$4,399 

$4,734 

$9,941 

The  extraordinary  growth  of  the  trtist  companies  is  largely 
attributable  to  the  inherent  competitive  advantages  of  the  non- 
specialized  type  of  financial  institution.  The  fact  that  many 
types  of  financial  operations  are  conducted  in  one  building  and 
under  one  management  makes  possible  a  most  efficient  utiliza- 
tion of  the  financial  resources  of  the  institution,  for  by  virtue 
of  the  variety  of  services  that  are  rendered,  the  officials  of  such 
an  institution  can  be  more  closely  in  touch  with  all  phases  of 
financial  and  business  problems  than  can  those  of  a  specialized 
institution.  The  analysis  of  the  interrelations  of  financial 
operations  and  of  the  interdependence  of  finance  and  business 
that  has  been  made  in  preceding  chapters  should  make  it 
apparent  that  an  institution  which  by  the  nature  of  its  work 

»  Report  of  the  Comptroller  of  tke  Cufrertcy^  II  (1918),  144,  790,  814, 


728         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

must  keep  in  touch  with  every  aspect  of  the  economic  and 
financial  system  would  naturally  be  more  far-seeing  and  hence 
more  efficient  in  its  management  than  would  one  which  from 
the  nature  of  its  operations  was  brought  into  contact  with  only 
certain  phases  of  the  system. 

The  department-store  type  of  financial  institution  also 
has  certain  direct  advantages  in  attracting  business.  One  class 
of  service  naturally  calls  the  attention  of  customers  to  the 
other  classes  of  service;  each  department  reinforces  the  others. 

If  the  trustee  needs  to  deposit  money,  the  banking  department  is 
at  hand;  if  the  investor  wishes  to  buy  or  sell,  be  it  real  estate,  or 
stocks  or  bonds,  the  corporation  is  ready;  if  the  agent  finds  a  pur- 
chaser or  a  renter,  that  person  is  attracted  toward  the  company; 
if  the  depositor  wishes  any  of  the  services  of  the  company,  he  is  made 
to  realize  the  helpfulness  of  his  banker;  if  a  new  company  is  to  be 
opened  up  through  promotion  of  the  enterprises  incident  thereto, 
then  there  is  a  distinct  drawing  of  the  general  patronage  in  the 
direction  of  the  company;  if  the  individual  has  any  of  the  needs 
which  are  suppUed  by  the  company  in  active  life  and  business,  he  is 
drawn  to  the  company  when  he  has  a  sp>ecial  trust  to  be  performed 
whether  during  his  life  or  after  death  ....  and  so  it  is  one  interest 
attracts  another.' 

Aside  from  these  administrative  advantages  the  trust 
companies  have  also  possessed  certain  special  advantages  over 
corrmiercial  banks  because  of  the  less  rigid  legal  requirements 
governing  loans,  reserves,  etc.  While  there  were  undoubtedly 
certain  dangers  attending  such  lax  regulation,  particularly 
in  view  of  the  diversity  of  operations  conducted,  the  trust 
companies  were  nevertheless  enabled — so  long  as  failures  did 
not  shatter  the  pubUc's  confidence — to  earn  very  large  profits. 
And,  on  the  whole,  trust  company  failures  have  not  been  much 
more  common  than  those  of  state  and  national  banks,  the 
number  between  1893  and  1908  equaling  .70  of  one  per  cent 
of  the  total  number  of  trust  companies,  as  compared  with  .61 
and  .49  of  one  per  cent  for  state  and  national  banks  respectively. 

'  Bankers'  Magazint  (April,  iqcjq),  p.  637.  ' 


FINANCIAL  INTEGRATION  729 

It  is  possible,  however,  that  this  comparatively  good  showing 
of  the  trust  companies  may  be  attributed  to  the  fact  that  the 
commercial  banks,  particularly  the  national  banks  of  the 
reserve  centers,  were  obliged  to  serve  as  the  repositories  of 
cash  which  supported  the  entire  credit  structure,  including 
that  erected  on  slender  trust  company  reserves. 

Commercial  hanks  ultimately  found  it  expedient  to  engage  in 
trust  company  operations.  When  the  commercial  banks  found 
it  impossible  to  prevent  the  development  of  this  "dangerous 
and  illegitimate"  type  of  financial  institution  known  as  the 
trust  company,  with  interesting  inconsistency  they  promptly 
sought  to  extend  the  scope  of  their  own  operations  to  include  the 
whole  range  of  trust  business.  This  development  in  turn 
incurred  the  enmity  of  the  trust  companies  which  henceforth 
inconsistently  exerted  all  possible  influence  to  confine  the 
activities  of  commercial  banks  to  their  "legitimate"  field  of 
financial  enterprise. 

But  the  drift  toward  financial  integration  could  not  be 
checked;  and  by  19 10  fifteen  states  had,  in  fact,  granted  to 
commercial  banks  the  power  to  accept  and  execute  trusts. 
While  national  banks  were  not  successful  in  securing  permission 
to  engage  in  trust  company  business  until  the  passage  of  the 
Federal  Reserve  law,  they  had,  however,  by  devious  methods 
succeeded  in  engaging  in  trust  company  business  long  before 
1914.  The  method  most  commonly  employed  was  for  the 
managers  of  a  national  bank,  or  a  state  bank,  in  states  where 
commercial  banks  were  not  permitted  to  engage  in  trust  com- 
pany business,  to  organize  an  affiliated  trust  company,  which 
would  be  conducted  with  a  "community  of  interest"  with  the 
commercial  bank.  The  common  management  of  the  Mercan- 
tile Savings  and  Trust  Company  and  the  Mercantile  National 
Bank  of  St.  Louis  is  an  example.  According  to  the  Secretary 
of  the  Treasury,  MacVeagh,  there  were  in  191 1  some  three 
hundred  cases  of  this  sort.  A  second  method  was  also  fre- 
quently practiced — that  of  selling  a  majority  of  the  stock  of  a 
national  bank  to  a  trust  company,  thereby  effecting  in  practice 
a  virtual  consolidation  of  the  two  institutions. 


730  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  Federal  Reserve  Act  authorizes  national  hanks  to  engage 
in  trust  business.  The  facts  as  to  the  inevitable  trend  of 
financial  development  were  eventually  looked  in  the  face, 
for  we  find  that  the  Federal  Reserve  Act  has  empowered  the 
Federal  Reserve  Board  to  grant  by  special  permit  to  national 
banks  applying  therefor  "when  not  in  contravention  of  state  or 
local  law,  the  right  to  act  as  trustee,  executor,  administrator, 
registrar  of  stock  and  bonds,  under  such  rules  and  regulations 
as  the  said  board  may  prescribe."  Under  this  authorization 
a  number  of  national  banks  promptly  made  application  for 
permission  to  assume  trust  functions. 

This  threatened  deprivation  of  the  special  advantages  so 
long  enjoyed  by  trust  companies,  led  them  to  charge  that  the 
Federal  Reserve  authorization  was  unconstitutional,  and  two 
test  cases  were  shortly  brought  before  the  state  coiirts,  in 
Illinois  and  Michigan.  Both  decisions,  handed  down  in 
December,  1915,  and  September,  1916,  respectively,  held  that 
the  granting  of  trust  powers  to  national  banks  was  unconsti- 
tutional. But  upon  appeal  to  the  Supreme  Court  of  the 
United  States,  the  decisions  were  reversed  and  congressional 
authority  to  grant  trust  powers  to  national  banks  was  con- 
clusively established,  the  issue  being  decided  on  the  principle 
of  implied  powers  laid  down  in  the  famous  case  of  McCulloch 
versus  Maryland- 
State  commercial  hanks  are  also  being  granted  trust  powers. 
One  further  step  was  required  to  make  department-store  bank- 
ing a  universal  phenomenon  in  the  United  States;  for  there 
were  still  many  states  that  had  not  granted  trust  powers  to 
commercial  banks.  Unable  longer  to  withstand  the  tide, 
the  New  York  legislature,  on  July  9,  19 19,  amended  the  state 
banking  law  and  gave  to  the  Superintendent  of  Banking  the 
power  to  grant  to  banks  applying  therefor  the  right  to  "act  as 
trustee,  executor,  administrator,  registrar  of  stocks  and  bonds, 
guardian  of  estates,  trustee  and  receiver  of  estates  of  lunatics, 
or  in  any  other  fiduciary  capacity  in  which  trust  companies 
are  permitted  to  act."  It  is  believed  that  the  remaining 
states  will  promptly  fall  into  line. 


FINANCIAL  INTEGRATION  73 1 

There  has  been  a  similar  integration  in  the  field  of  savings 
banking.  Attention  has  elsewhere  been  directed  to  the  assump- 
tion of  savings  bank  functions  by  commercial  banks  and  to  the 
specific  recognition  by  the  Federal  Reserve  law  of  the  existence 
of  savings  accounts  in  national  banks.'  The  truth  is  that  during 
the  last  ten  years  the  volume  of  savings  accounts  in  savings 
banks  has  increased  only  about  10  per  cent;  while  that  in 
state  and  national  commercial  banks  has  increased  20  and 
35  per  cent  respectively.  Moreover,  the  volume  of  savings 
accounts  in  all  commercial  banks  now  constitutes  over  40  per 
cent  of  the  total  savings  deposits  in  the  United  States. 

We  have  also  seen  that  in  recent  years  the  savings  banks 
have  invaded  the  field  of  commercial  banking,  and  that  in 
consequence  the  problem  of  savings  bank  management  is  now 
very  nearly  identical  with  that  of  commercial  bank  manage- 
ment. Most  savings  bank  deposits  are  in  fact  payable  on 
demand;  and  it  is  recognized  that  the  maintenance  of  liquid 
assets,'  or  of  a  ready  access  to  the  reserve  resources  of  com- 
mercial banks  is  a  first  requisite  in  sound  savings  bank 
management. 

This  integrating  movement  in  the  field  of  savings  banking 
has  passed  through  practically  the  same  stages  as  the  trust 
company  development.  Just  as  the  commercial  banks  resorted 
to  the  courts  to  prevent  the  encroachment  of  trust  companies 
upon  their  "  legitimate  "  field  of  enterprise,  so  the  savings  banks 
appealed  to  the  courts  for  protection  when  the  commercial 
banks  first  began  to  invade  their  financial  preserves;^  and  just 
as  the  commercial  banks,  when  they  could  not  prevent  the 
usurpation  of  commercial  banking  functions  by  trust  companies, 
retaUated  by  entering  the  field  of  trust  enterprise,  so  in  like 
manner  the  savings  banks — unable  to  check  the  invasion  of 

'  See  pp.  334-35- 

'  See  pp.  341-43.  In  the  light  of  this  recognition  many  states  have, 
during  the  last  few  years,  legalized  bank  acceptances  as  savings  bank 
investments. 

i  See,  for  example,  The  People  v.  BinghanUon  Trust  Company,  139 
New  York,  185  (1890). 


732^       THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

their  traditional  field  by  the  commercial  banks  (and  of  course 
by  the  trust  companies),  have  broadened  the  scope  of  their 
operations  by  taking  over  commercial  banking  functions.  They 
are,  moreover,  now  aspiring  to  assume  trust  functions  as  well.* 

II.    POSSIBLE   DANGERS   OF   DEPARTMENT-STORE 
BANKING 

It  has  been  urged  by  some  that  department-store  financial 
institutions  contain  elements  of  serious  weakness  and  that 
great  care  must  be  taken  if  we  are  to  avoid  a  substantial  deterio- 
ration in  banking  methods.  There  are  two  grounds  for  this 
contention.  First,  it  is  urged  that  such  an  institution  becomes 
a  Jack-of-all-trades  and  master  of  none — that  ''only  by  speciali- 
zation can  the  highest  efficiency  be  attained."  A  sufficient 
answer  to  this  contention,  at  least  with  large  institutions, 
appears  to  lie  in  the  fact  that  there  may  be  just  as  efficient 
management  of  the  specialized  departments  of  a  single  business 
as  of  specialized  distinct  businesses.  And  in  addition,  as  we 
have  already  seen,  there  is  a  decided  advantage  in  bringing  to 
bear  upon  the  organization  of  the  institution  as  a  whole  the 
varied  knowledge  and  ability  of  the  different  department 
managers.  The  slightly  greater  percentage  of  trust  company 
failures  in  the  past  is  not  to  be  attributed  so  much  to  the 
diversity  of  functions  performed  as  to  the  low  reserve 
requirements  and  other  lax  regulations  imposed  by  state  laws 
in  the  past. 

Of  more  significance,  however,  is  the  possibility  that  such 
an  institution  might  fail  to  keep  the  accounts  of  the  different 
departments  separate  and  to  conduct  each  department  on  the 
principles  demanded  by  the  nature  of  its  particular  type  of 
operation.  Mindful  of  this  possibility,  the  Federal  Reserve 
Board  requires  of  the  national  banks  exercising  trust  company 
powers  that  "the  funds,  securities,  and  investments  held  in 

'  For  a  study  of  integration  in  the  field  of  savings  banking  see  W.  K 
Tang,  Savings  Bank  Development  in  the  United  States  (a  Master's  thesi- 
at  the  University  of  Chicago),  1920. 


FINANCIAL  INTEGRATION  733 

each  trust  shall  be  held  separate  and  distinct  from  the  general 
funds  and  securities  of  the  bank,  and  separate  and  distinct 
one  from  another.  The  ledger  and  other  books  kept  for  the 
trust  department  shall  be  entirely  separate  and  apart  from  the 
other  books  and  records  of  the  bank. " 

If  the  legal  regulations  governing  the  operations  of  the 
various  types  of  financial  institutions  are  sound  and  if  through 
regulation  and  supervision  we  make  certain  that  the  work  of 
each  department  shall  be  conducted  on  correct  principles,  there 
would  seem  to  be  little  occasion  for  concern  over  the  future 
efficiency  of  oiu:  department-store  financial  administration. 

III.    THE  UNIFICATION  OF  THE  BANKING  SYSTEM 

The  development  of  banking,  as  of  other  economic  insti- 
tutions in  the  United  States,  has  been  profoundly  influenced 
by  our  dual  system  of  government.  We  have  already  seen 
that  until  the  period  of  the  Civil  War  our  banking  system  was 
quite  chaotic  because  of  the  diverse  legal  regulations — or 
absence  of  them— in  the  different  states  of  the  Union.  With 
the  establishment  of  the  national  banking  system  we  seciured  a 
uniform  bank  note  currency  and,  so  far  as  the  national  banks 
were  concerned,  uniform  regulation  of  banking  operations. 
But  the  diverse  regulations  of  state  banking  still  persisted. 
Moreover,  in  consequence  of  the  lessening  importance  of  the 
note  issue  function  of  commercial  banks  and  the  greater  range 
of  powers  generally  granted  under  state  banking  laws,  state 
banks  increased  in  nimiber  after  1885,  as  is  indicated  in  the 
chart  on  page  354,  even  more  rapidly  than  did  national  banks. 

There  is  undoubtedly  something  to  be  said  for  this  dual 
system  in  that  it  has  given  a  greater  scope  for  experimentation 
in  banking  than  would  otherwise  have  been  possible.  For 
example,  the  development  of  the  department-store  type  of 
financial  institution  would  probably  not  have  been  possible 
if  all  financial  institutions  had  been  chartered  from  the  beginning 
by  the  national  government ;  and  certain  it  is  that  the  extension 
of  the  privilege  of  making  loans  (within  limitations)  by  national 


734  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

banks  on  real  estate  would  long  ha\'e  been  delayed  had  it  not 
been  for  the  competitive  influence  of  state  banks,  which  have 
always  been  permitted  to  loan  at  least  a  portion  of  their  funds 
for  such  purposes.  The  establishment  of  the  Federal  Reserve 
System,  however,  revealed  a  striking  weakness  in  our  banking 
organization,  one  inherent  in  the  dual  system  of  government. 

Under  the  simple  conditions  of  industry  that  prevailed  in 
colonial  days  the  regulation  of  banking  could  well  be  conceived 
as  essentially  a  local  or  state  problem.  But  with  the  evolution 
during  the  nineteenth  century  of  our  system  of  large-scale 
interdependent  industry  which  is  intimately  interwoven  with 
the  deUcately  adjusted  financial  structure,  the  problem  of 
banking  organization  and  control  has  been  entirely  changed. 
The  interdependence  of  financial  institutions,  as  we  have 
repeatedly  seen,  is  a  striking  characteristic  of  the  credit  system ; 
whether  under  state  or  federal  law,  whether  engaging  in  opera- 
,  tions  intra-state  or  inter-state,  the  failure  of  any  important 
bank  has  its  effect  upon  the  entire  banking  and  credit  structure. 

When  the  Federal  Reserve  Act,  therefore,  undertook  to 
mobilize  the  nation's  resources  and  to  prevent  the  recurring 
collapse  of  the  credit  system  in  times  of  panic,  as  well  as  to 
minimize  the  ebb  and  flow  of  business  activity,  it  was  apparent 
that  the  lack  of  conf  ol  -ver  state  financial  institutions  was  a 
matter  of  serious  concern.  How  could  a  system  half-organized 
and  half-unorganized,  survive  the  credit  strains  of  a  period  of 
financial  crisis  and  how  could  such  a  system  effect  any  substan- 
tial control  during  the  upward  swing  of  the  business  cycle  ? 
In  a  word,  how  could  a  financial  house  divided  against  itself 
stand  ? 

The  admission  of  state  hanks  into  the  Federal  Reserve  System 
has  strengthened  the  credit  structure.  The  Federal  Reserve  Act 
made  possible  the  entrance  of  state  banks  and  trust  companies 
into  the  Federal  Reserve  System  under  conditions  to  be  for- 
mulated by  the  Federal  Reserve  Board.  And  in  order  to 
strengthen  the  financial  structure  as  much  as  possible  the 
board  early  prepared  and  issued  regulations  relating  to  the 
admission  of  state  banks  to  membership  in  the  Federal  Reserve 


FINANCIAL  INTEGRATION  735 

System.  Foreseeing  the  impossibility  of  inducing  state  insti- 
tutions to  enter  the  system  if  the  broad  powers  that  had  been 
conferred  upon  them  under  state  laws  were  curtailed,  the 
Federal  Reserve  Board  felt  that  the  conditions  of  membership 
should  not  preclude  state  institutions  from  exercising  their 
statutory  rights  under  state  laws  as  before.  For  example, 
they  are  therefore  permitted  to  make  loans  on  real  estate 
security  without  regard  to  the  restrictions  imposed  upon  the 
making  of  such  loans  by  national  banks;  although  the  Board 
reserved  the  right  to  refuse  entrance  into  the  system  to  a  state 
bank  which  had  so  large  a  percentage  of  its  loans  invested  in 
real  estate  as  to  impair,  in  the  view  of  the  Board,  its  liquid 
condition.  The  state  banks  were  also  given  permission  to 
withdraw  from  the  system  on  a  year's  notice  if  after  trial  they 
did  not  find  membership  advantageous. 

A  vigorous  effort  was  made  on  the  part  of  the  Federal 
Reserve  Board  to  induce  the  state  banks  to  join  the  system. 
The  great  advantages  of  membership  were  pointed  out;  and 
veiled  threats  were  made  to  the  effect  that  in  case  the  state 
banks  did  not  join,  in  time  of  crisis  they  would  be  unable  to 
secure  any  assistance  in  meeting  the  strain  to  which  they  would 
be  subjected.  But  until  after  the  United  States  had  entered 
the  European  war  the  state  banks  were  very  reluctant  to 
associate  themselves  with  the  Federal  Reserve  System.  The 
arguments,  misconceptions,  and  prejudices  which  explain  their 
refusal  to  take  early  advantage  of  the  opportunity  to  enter 
the  system  are  best  presented  in  the  words  of  a  state  banker, 
as  follows: 

There  are  many  reasons  why  state  banks  and  trust  companies 
should  act  with  great  deUberation  with  reference  to  entering  the  new 
Federal  Reserve  Banking  Sjrstem,  and  I  will  undertake  to  mention  a 
few  of  them  very  briefly. 

First,  the  law  is  made  for  national  banks  only.  Until  it  shall  be 
so  amended  as  to  be  helpful  and  not  detrimental  to  state  banks  and 
trust  companies  they  should  remain  out  of  the  system. 

Second,  those  entering  the  new  system  will  probably  be  subject 
to  double  examinations,  both  state  and  national,  double  reports, 


736         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

conflicting  laws,  unusual  expenses,  and  a  curtailment  of  privileges 
now  enjoyed  under  state  laws. 

Third,  at  the  present  time  state  banks  and  trust  companies  are 
able  to  supply  needs  in  their  various  communities  for  the  develop- 
ment and  promotion  of  business  that  cannot  be  supplied  by  national 
banks.  This  then  brings  us  face  to  face  with  the  best  protection  of 
the  public  and  the  fullest  development  of  the  country.  The  new  law 
appears  to  me  to  have  been  especially  constructed  for  and  is  now 
being  administered  largely  for  the  benefit  of  big  business  and  big 
undertakings.  It  has  no  functions  thus  far  developed  that  appeal 
personally  and  directly  to  the  small  business  man,  merchant,  small 
farmer,  small  stock-raiser,  small  manufacturer,  or  plain  ordinary 
citizen.  Of  course,  by  aiding  the  large  institutions,  the  system  will 
probably  indirectly  aid  the  small  ones. 

In  the  fourth  place,  commercial  paper  is  the  great  and  important 
item  to  be  used  for  rediscounts  at  the  Federal  Reserve  banks.  This 
can  be  issued  and  is  issued  only  by  large  concerns  moving  great 
quantities  of  merchandise  or  products  and  receiving  quick  returns 
on  the  same  in  cash.  Theoretically  this  is  fine,  but  unfortunately 
all  of  the  business  of  the  country  is  not  and  cannot  be  turned  over 
inside  of  thirty,  sixty,  or  ninety  da)^.  There  should  therefore  be 
some  financial  institutions  in  the  country  that  can  take  on  at  least  a 
limited  amount  of  such  business  which  is  sound,  safe,  and  secure, 
but  not  as  quickly  liquid  as  the  preferred  classes  mentioned  in  the 
reserve  bank  act. 

Fifth,  customers  of  country  banks  know  very  little  about  making 
statements,  and  it  would  be  very  difficult  for  a  country  bank  to  meet 
the  "red-tape"  requirements  of  the  Federal  Reserve  banks  when 
discounts  are  needed.  A  statement  must  be  filed  for  the  maker  of 
each  note  offered  for  rediscount,  certain  application  blanks  must  be 
filled  out  and  filed,  and  a  great  deal  of  necessary  routine  gone  through 
before  a  loan  can  be  secured  or  paper  rediscounted.  I  believe  the 
small  member  banks  and  non-member  banks  must  rely,  as  heretofore, 
largely  upon  their  correspondents  in  the  larger  centers  to  supply  them 
with  funds  as  needed  for  emergencies.  Fortunately,  such  banks  do 
not  need  accommodations  very  often. 

Sixth,  it  would  be  very  dangerous  to  place  the  entire  banking 
business  of  the  country  under  the  control  of  a  federal  board  at  Wash- 
ington. No  other  free  country  that  I  know  of  has  ever  succeeded  in 
forcing  all  banking  institutions  to  come  under  absolute  governmental 
control. 


FINANCIAL  INTEGRATION  737 

Is  it  not  unwise  to  take  on  the  risks  and  the  obligations  entailed  by 
becoming  members  of  the  reserve  system  when  it  is  not  necessary  to 
do  so  ?  While  there  are  benefits  and  advantages  to  those  banks  that 
are  members  of  the  system,  these  are  more  or  less  counterbalanced 
at  this  time  by  the  risks,  curtailment  of  privileges,  limitation  of  func- 
tions, added  expenses,  and  other  disadvantages  offered  by  the  system. 

State  banks  and  trust  companies  are  in  a  very  fortunate  position, 
both  for  themselves  and  for  their  patrons,  in  being  able  to  stand  aside 
during  the  formative  period — we  might  say  the  experimental  stage — of 
the  new  national  banking  system  and  steady  the  financial  ship  while 
the  national  banks  trim  their  sails  and  adjust  their  craft  to  suit  the 
current  of  the  new  stream.  These  twenty  thousand  or  more  state 
banks  and  trust  companies,  remaining  serene  and  imdisturbed,  are 
able  to  take  care  of  their  business  in  the  usual  way,  co-operating  at  all 
times  in  a  most  friendly  and  patriotic  spirit  in  bringing  the  new 
national  system  to  its  highest  efficiency  and  most  perfect  state  of 
usefulness.' 

Shortly  after  the  entrance  of  the  United  States  into  the 
war  a  new  drive  for  securing  the  membership  of  the  state  banks 
was  undertaken.  Mobilization  was  the  task  of  the  time, 
mobilization  of  the  army  and  navy,  mobilization  of  manpower 
and  womanpower,  mobilization  of  labor,  mobilization  of 
industrial  resources.  Why  not,  therefore — ^most  important 
of  all — ^mobilization  of  the  nation's  financial  resources  ?  Presi- 
dent Wilson  seized  the  psychological  opportunity  and  issued 
a  stirring  appeal  to  state  bankers  to  join  the  Federal  Reserve 
System  and  thereby  to  effect  a  complete  mobilization  of  the 
banking  resources  of  the  United  States.  He  urged  "that 
co-operation  on  the  part  of  the  banks  is  a  patriotic  duty  at 
this  time  and  membership  in  the  Federal  Reserve  System  is 
a  distinct  and  significant  evidence  of  patriotism. " 

While  this  appeal  doubtless  had  no  little  effect,  the  credit 
strain  to  which  the  individual  banks  were  already  subjected 
was  probably  a  more  potent  influence  in  inducing  the  state 
banks  to  affiliate  with  the  Federal  Reserve  System.  The 
expanding  volume  of  business  conducted  at  ever-increasing 

'  Frank  N.  Briggs,  adapted  from  an  address  before  the  Colorado 
Bankers  Association,  June  30,  1915. 


738  THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

prices — as  explained  in  chapter  xxvi — ^necessitated  access, 
directly  or  indirectly,  on  the  part  of  the  state  banks  to  the 
central  repositories  of  reserve  money.  The  apathy  that  had 
previously  prevailed  with  reference  to  the  rediscount  privilege 
was  thus  changed  as  if  by  magic  to  the  liveUest  interest.  It 
had  become  highly  profitable  to  afloliate  with  the  Reserve 
System. 

The  number  of  state  banks  and  trust  companies  that  had 
been  admitted  to  membership  in  the  Federal  Reserve  System 
by  August  I,  1920,  was  1,401,  having  a  total  capital  and  surplus 
of  $986,045,028,  with  combined  resources  of  $9,840,912,065. 
Although  only  about  one-fifteenth  of  the  total  number  of  state 
banks  have  as  yet  become  members  of  the  Federal  Reserve 
System,  about  one-third  of  all  the  state  banking  resources  are 
now  joined  with  the  system,  since  nearly  all  the  large  state 
institutions,  including  trust  companies,  have  entered  the  fold. 

We  shall  no  doubt  ultimately  find,  therefore,  that  the  growth 
of  department-store  banking  and  the  development  of  the 
Federal  Reserve  System  as  a  means  of  controlling  the  credit 
mechanism  and  rendering  it  subservient  to  the  varying  require- 
ments of  business,  will  have  given  us  a  unified  and  genuinely 
national  system  of  finance.  While  there  has  been  little  suggestion 
as  yet  that  savings  banks  should  be  admitted  to  membership  in 
the  Federal  Reserve  System,  in  view  of  the  growing  similarity 
of  the  business  conducted  by  savings  and  commercial  banking 
institutions,  it  is  difficult  to  find  any  good  reason  for  excluding 
them.  On  the  contrary,  the  admission  of  savings  banks  to 
membership  in  the  Federal  Reserve  System  and  the  extension 
to  them  in  times  of  emergency  of  the  privileges  of  rediscount, 
would  appear  to  add  one  more  pillar  of  strength  to  the  financial 
structure. 

QUESTIONS  FOR  DISCUSSION 

1.  To  what  extent  do  the  banks  with  which  you  are  familiar  specialize 
in  some  particular  form  of  financial  enterprise  ? 

2.  Do  you  imagine  that  some  one  department  of  a  non-specialized 
institution  is  of  paramount  importance,  with  the  others  merely 
incidental,  or  that  all  are  of  relatively  equal  importance  ? 


FINANCIAL  INTEGRATION  739 

3.  If  you  were  to  organize  a  bank  of  ample  resources,  how  many 
departments  would  you  create?  What  conditions  wotdd 
determine  your  policy  in  this  connection  ? 

4.  Examine  the  mutual  and  stock  savings  bank  balance  sheets  on 
pages  328  and  333-34  and  estimate  the  relative  importance  of 
the  commercial  business  in  each  class  of  savings  institution. 

5.  Do  savings  bank  balance  sheets  show  whether  the  bank  conducts 
a  bond  or  trust  department  ? 

6.  Would  the  balance  sheet  of  a  trust  company  indicate  the  extent 
of  (o)  its  trust  business  (of  the  various  tjrpes);  (b)  its  under- 
writing activites;  (c)  its  savings  business? 

7.  Does  the  balance  sheet  of  a  commercial  bank  indicate  (a)  its 
savings  business;  (b)  its  bond  transactions;  (c)  its  trust  business  ? 

8.  What  conclusions  do  you  draw  from  a  study  of  the  tables  on 
pages  726  and  727  ? 

Q.  "The  tendency  toward  financial  integration  is  caused  by  the 
same  forces  that  have  produced  integration  in  industry."  Dis- 
cuss this  statement. 

10.  Draw  up  a  list  of  the  advantages  of  the  department-store  type  of 
financial  institution.     Draw  up  a  list  of  the  disadvantages. 

ii.  "All  that  is  necessary  to  safeguard  department-store  banking 
is  to  require  the  operations  and  accoimts  to  be  kept  entirely 
separate. "    Why  ? 

12.  "It  is  only  in  the  larger  cities  that  the  department-store  type 
of  institution  could  prove  successful. "    Do  you  agree  ? 

13.  "In  towns  and  smaller  cities  there  is  not  enough  financial  business 
to  support  several  different  types  of  financial  institutions.  If 
the  community  is  to  be  adequately  served  with  financial  facilities, 
therefore,  a  single  bank  must  be  permitted  to  do  various  kinds  of 
business. "     What  do  you  think  of  this  statement  ? 

14.  How  do  you  account  for  the  fact  that  financial  legislation  origi- 
nally intended  to  force  the  development  of  specialized  financial 
institutions  ? 

15.  How  do  you  account  for  the  fact  that  writers  on  the  theory  of 
banking  have  usually  written  as  though  the  different  types  of 
financial  operations  were  conducted  by  specialized  institutions? 

16.  "The  enormous  profits  from  promotions,  underwritings,  and 
security  purchases  in  the  investment  field  have  led  to  a  revolu- 
tionary change  in  the  conduct  of  our  leading  banking  institutions. 
It  was  obvious  that  control  by  the  investment  bankers  of  the 


740         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

deposits  in  banks  and  trust  companies  was  an  essential  element  in 
their  securing  these  huge  profits.  And  the  bank  officers  naturally 
asked,  'Why,  then,  should  not  the  banks  and  tnist  companies 
share  in  so  profitable  a  field  ?  Why  should  not  they  themselves 
become  investment  bankers,  too,  with  all  the  new  functions 
incident  to  Big  Business  ? '  To  do  so  would  involve  a  departure 
from  the  legitimate  sphere  of  the  banking  business,  which  is  the 
making  of  temporary  loans  to  business  concerns.  But  the 
temptation  was  irresistible.  The  invasion  of  the  investment 
banker  into  the  bank's  field  of  operation  was  followed  by  a 
counter-invasion  by  the  bank  into  the  realm  of  the  investment 
banker."  Do  you  regard  this  tendency  as  inimical  to  sound 
banking  ? 

17.  "Unquestionably  the  special  temptation  to  which  our  banks  are 
now  subjected  is  the  temptation  to  turn  from  commercial  to 
financial  banking;  to  change  from  the  buying  and  selling  of 
commercial  credit  to  investments  in  securities  and  loans  extended 
to  promote  financial  enterprise ;  in  short,  to  change  their  business 
from  that  of  commercial  banks  to  that  of  finance  companies. 
Concentration  in  banking,'  which  is  going  on  at  such  a  rapid  rate 
in  New  York,  would  not  be  open  to  much  or  any  criticism  if 
such  concentration  was  employed  for  the  purpose  of  facilitating 
the  commerce  of  the  country  instead  of  being  used  in  purely 
financial  undertakings. "    Criticize  this  statement. 

18.  A  few  years  ago  the  president  of  a  large  New  York  bank  stated 
in  a  public  address  that  it  was  bad  banking  practice  for  a  com- 
mercial bank  to  invest  its  funds  in  anything  but  paper  growing 
out  of  short-time  commercial  transactions.  At  the  time  his  own 
bank's  balance  sheet  showed  "Investments  in  bonds,  securities, 
etc.,"  equal  to  nearly  25  per  cent  of  the  total  "Loans  and  dis- 
counts. "    How  do  you  account  for  his  statement  ? 

ig.  How  do  you  explain  the  development  of  savings  departments  by 
commercial  banks  ?  of  bond  distributing  departments  ? 

20.  Should  the  commercial  paper  house  be  allowed  to  invade  the 
field  of  investment  banking  ? 

21.  Why  does  not  the  commercial  paper  house  assume  trust,  saving, 
and  commercial  banking  functions?  May  it  some  day  con- 
ceivably do  so  ? 

'  See  pp.  761-63, 


FINANCIAL  INTEGRATION  741 

22.  Why  do  the  commercial  banks  not  organize  affiliated  com- 
mercial paper  houses,  as  they  do,  in  fact,  organize  affiliated 
cattle  loan  companies  ? 

23.  How  do  you  explain  the  extension  of  commercial  banking  powers 
to  trust  companies  ?    Do  you  think  it  was  a  mistake  ? 

24.  How  do  you  explain  the  active  opposition  of  the  commercial 
banks  to  the  invasion  of  their  field  by  the  trust  companies? 
Would  the  opposition  have  been  as  bitter  as  it  was  if  the  trust 
companies  had  been  subjected  to  as  strict  legislative  regulation 
and  supervision  as  were  the  commercial  banks  ? 

25.  How  do  you  account  for  the  extension  of  trust  powers  to  com- 
mercial banks  ?    Do  you  think  it  unwise  ? 

26.  How  do  you  account  for  the  opposition  of  the  trust  companies 
to  the  entrance  of  national  and  state  banks  into  the  trust  field  ? 

27.  In  what  respects  has  the  banking  system  been  "unified"  as  a 
result  of  recent  banking  legislation  ? 

28.  How  do  you  account  for  the  persistent  growth  of  state  banking 
in  the  United  States?  In  what  respects  may  this  be  regarded 
as  having  had  advantages  ?    Disadvantages  ? 

29.  "The  industrial  and  financial  structure  is  essentially  national  in 
scope.  Therefore  the  control  of  our  banking  organization 
should  be  exclusively  vested  in  the  national  government." 
Do  you  agree  ? 

30.  "The  phenomena  of  the  business  cycle  conclusively  demonstrate 
the  desirabihty  of  a  unified  banking  organization. "    If  so,  how  ? 

31.  Do  you  regard  any  of  the  arguments  advanced  on  pages  734-35 
against  the  entrance  of  state  banks  into  the  Federal  Reserve 
System  as  sound  ?  How  do  you  explain  the  advancing  of  such 
arguments  ? 

32.  Until  the  year  191 6  nearly  hal  of  the  national  banks  of  the 
country  were  opposed  to  the  Federal  Reserve  System.  How 
do  you  explain  this  fact?  How  do  you  explain  the  recent 
imanimous  indorsement  of  the  system  by  the  American  Bankers 
Association,  whose  membership  consists  of  both  national  and 
state  banks  ? 

33.  "The  financial  system  will  not  be  completely  unified  nor  sub- 
jected to  adequate  government  control  until  all  forms  of  financial 
enterprise  are  placed  under  the  supervision  of  the  federal  govern- 
ment." Review  the  charts  on  pages  136  and  650;  re-read 
pages  486-88;  paragraphs  2  and  3  on  page  529;  and  paragraph  2 
on  page  537 — and  then  discuss  the  above  statement. 


CHAPTER  XXX 

THE  FINANCIAL  SYSTEM  AND  THE  GENERAL 
ECONOMIC  ORGANIZATION 

Our  study  of  the  work  of  the  various  financial  agencies 
and  institutions  which  together  comprise  the  financial  structure 
of  the  modern  economic  system  is  now  completed.  It  remains 
to  attempt  in  this  final  chapter  a  statement,  however  inade- 
quate, of  the  significance  of  this  financial  structure  from  the 
point  of  view  of  the  general  economic  organization  of  which 
it  forms  so  integral  and  so  important  a  part.  What,  in  general, 
are  the  elements  of  strength  and  of  weakness  in  an  economic 
system  that  is  organized  on  a  pecuniary  basis  ?  What  problems 
of  economic  or  social  control  have  resulted  from  the  evolution 
of  the  modern  financial  system?  Does  this  system  in  all 
respects  give  rise  to  a  well-ordered  economic  Ufe  and — to  borrow 
a  statement  of  the  ends  and  aims  of  human  society  that  has 
yet  to  be  improved  upon — does  it  on  the  whole  "promote  the 
greatest  good  of  the  greatest  number"  ?  It  is  scarcely  necessary 
to  say  that  a  satisfactory  or  adequate  answer  to  these  questions 
is  impossible;  all  that  can  be  attempted  in  this  chapter  is  to 
make  some  suggestive  statements  with  reference  to  the  economic 
significance  of  the  modern  financial  system  and  to  the  nature 
of  the  unsettled  problems  of  economic  control  to  which  this 
system  has  given  rise. 

The  economic  services  rendered  by  the  various  parts  of  the 
financial  structure  have  in  preceding  chapters  been  discussed 
in  connection  with  the  work  of  particular  financial  institutions 
and  agencies.  Here  and  there  also  in  the  course  of  the  treatise 
there  have  been  some  suggestions  of  the  interrelations  of 
financial  institutions — of  the  development  of  a  financial  struc- 
ture— and  of  the  larger  significance  of  this  financial  system  in 
relation  to  the  general  economic  organization  by  means  of  which 

74a 


FINANCE  AND  ECONOMIC  ORGANIZATION  743 

the  wants  of  mankind  are  supplied.  The  analysis  of  the  present 
chapter  will  therefore  consist  in  part  of  a  drawing  together  of 
the  threads  of  our  previous  discussion.  It  is  believed  that  such 
a  recapitulation,  with  the  necessary  elaboration  and  restate- 
ment, will  present  a  reasonably  complete  and  accurate  view  of 
the  interdependence  of  finance  and  business — of  the  relation  of 
the  financial  system  to  the  general  economic  organization. 

I.     MERITS  AND   DEFECTS  OF  THE 
PECUNIARY  MECHANISM 

The  pecuniary  system  has  undoubtedly  rendered  economic 
services  of  the  greatest  importance.  It  will  be  recalled  that 
the  evolution  of  the  pecuniary  unit  rendered  both  language  and 
numbers  Intelligible  for  the  purposes  of  business  and  thus  fur- 
nished the  necessary  basis  not  only  for  all  trade  but  for  all  business 
activity.  In  a  very  real  sense  the  pecuniary  unit  of  calculation, 
together  with  the  medium  of  exchange  and  the  standard  of 
deferred  pa)anents,  have  not  only  made  possible  but  have  been 
responsible  for  the  development  of  our  large  scale  co-operative 
exchange  society,  which,  with  all  its  weaknesses  and  evils,  is 
almost  universally  conceded  to  be  a  highly  efficient  form  of 
economic  organization,  so  far  as  its  productive  aspects  are 
concerned.  It  will  also  be  recalled  that  the  system  of  pecuniary 
accounting  stimulates  and  hastens  the  development  of  improved 
productive  processes  and  fosters  industrial  progress. 

In  the  main  it  may  also  be  said  that  the  financial  system  has 
been  fairly  responsive  to  changing  business  requirements.  The 
growing  size  of  business  estabhshments  and  the  gradual  uni- 
versalizing of  the  credit  method  of  conducting  business  has 
been  attended  by  a  commensurate — though  often  lagging — 
development  of  facilitating  financial  agencies  and  institutions. 
Indeed  the  whole  complex  financial  structure,  pictured  in  the 
charts  on  pages  134,  136,  and  650,  and  discussed  in  the  accom- 
panying chapters,  evolved  to  meet  the  needs  of  a  rapidly 
changing  economic  organization — a  changing  organization  for 
which  the  motivating  force  was  mainly  the  prior  development  of 


744         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

the  pecuniary  unit  and  the  capitalistic  form  of  .enterprise, 
dominated  by  the  spirit  of  gain.  It  will  doubtless  be  conceded 
that  the  various  financial  institutions  thus  developed,  notwith- 
standing the  numerous  weaknesses  that  have  been  pointed 
out  in  the  foregoing  chapters,  have,  in  view  of  the  remarkable 
rapidity  with  which  the  capitaUstic  industrial  system  has  ex- 
panded, fulfilled  in  reasonably  satisfactory  fashion  the  require- 
ments imposed  upon  them. 

The  financial  organization  also  has  some  very  real  short- 
comings. At  various  places  in  the  foregoing  analysis  attention 
has  been  called  to  certain  perversions  and  evils  in  the  pecuniary 
system.  In  chapter  v,  for  example,  emphasis  was  placed  upon 
the  dominating  and  pervasive  influence  of  the  pecuniary  system 
over  social  and  economic  standards  and  ideals.  It  was  seen 
that  the  almost  universal  expression  of  modem  economic 
activities  and  achievements  in  pecuniary  temjs  has  led  to  an 
exaltation  of  the  significance  of  money  that  has  done  much  to 
pervert  the  ideals  of  society.  While  even  under  a  non-pecuniary 
system  individuals  would  no  doubt  place  great  emphasis  upon 
things  material;  and  while  it  is  highly  important  to  bear  in 
mind  that  the  modern  worship  of  the  "almighty  dollar"  is  in 
a  sense  only  the  worship  of  the  material  goods  which  dollars 
will  buy,  there  is  Uttle  doubt  that  the  development  of  the 
pecuniary  system  has  tended  to  strengthen  materiaHstic 
impulses  and  to  intensify  the  struggle  for  gain.  The  acquisitive 
instincts  of  mankind  appear  to  find  greater  encouragement  as 
well  as  fuller  scope  for  development  under  a  pecuniary  system 
than  under  any  other  suggested  form  of  social  organization. 

Moreover,  as  we  have  seen,  the  importance  to  the  individual 
of  a  large  supply  of  money  has  led  to  the  all  but  universal 
assumption  that  it  is  equally  important  that  the  nation  as  a 
whole  have  a  large  and  a  rapidly  increasing  supply  of  money. 
This  fallacy  has  been  responsible  for  numerous  and  persistently 
recurring  social  movements  for  increasing,  in  one  way  or  another, 
the  national  supply  of  currency.  All  men  are  instinctively 
mercantilists  and  all  instinctively  rejoice  when  the  per  capita 
circulation  increases;    hence  a  not  inconsiderable  portion  of 


FINANCE  AND  ECONOMIC  ORGANIZATION  745 

organized  political  activity  in  every  country  has  centered 
around  the  attempt  to  achieve  through  an  increase  in  the 
quantity  of  currency  an  improvement  in  economic  conditions 
which  can  come  only  through  an  increase  of  productive  effi- 
ciency. It  remains  true,  however,  as  has  been  noted  in  various 
connections,  that  the  supply  of  currency  as  manifested  in  bank 
reserves  is  at  times  a  matter  of  no  httle  significance. 

Among  the  shortcomings  of  the  pecuniary  order  we  have 
also  noted  the  social  and  economic  consequences  of  changes 
in  the  level  of  prices.  This  is  no  doubt  the  most  serious  weak- 
ness of  the  financial  system.  While  no  attempt  has  been  made 
in  this  treatise  to  discuss  the  complex  forces  which  control 
price  movements  in  a  capitaUstic  society,  we  have  seen  that 
prices  are  in  a  more  or  less  constant  state  of  flux,  with  minor 
oscillations  in  connection  with  the  various  stages  of  the  business 
cycle,  and  with  major  secular  movements,  as  indicated  in  the 
diagram  on  page  31.  Price  changes,  as  noted  in  chapter  iii, 
often  cause  very  serious  maladjustments  in  the  incomes  of 
different  classes  of  society  and  result  in  social  discontent,  which 
on  occasion  may  lead  to  a  very  general  disorganization  of 
economic,  social,  and  political  life.  The  individual,  compelled 
to  order  his  life  in  pecuniary  terms  and  through  pecuniary 
agencies,  is  powerless  to  control  his  destiny  in  the  face  of  price 
movements  that  depend,  so  far  as  he  is  concerned,  upon  entirely 
adventitious  circumstances. 

The  modern  business  man  also  finds  his  productive  activities 
circumscribed  at  every  point  by  financial  considerations,  over 
many  of  which  he  has  but  httle  control.  Sudden  changes 
either  in  the  price  of  his  particular  product  or  in  the  general 
level  of  prices  may  at  one  time  give  him  exceptional  profits  and 
at  another  bring  him  to  the  verge  of  bankruptcy.  While  price 
movements  may  to  some  extent  be  forecasted  and,  in  conse- 
quence, preparations  may  be  made  for  taking  advantage  of  a 
rise  or  for  discounting  the  effects  of  a  fall,  it  is  seldom  possible 
to  avoid  all  losses  incident  to  price  changes;  and  for  the  rank 
and  file  of  business  men  who  are  quite  without  knowledge 
of  the  influences  governing  price  movements,  price  changes 


746         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

constitute  perhaps  the  most  baffling  problem  with  which  they 
have  to  deal. 

Prices  should  he  stabilized  if  possible.  The  economic  and 
social  losses  resulting  from  price  changes  have  naturally  given 
rise  to  various  suggestions  for  controlling  or  stabilizing  the 
level  of  prices.  We  cannot  here  enter  upon  a  discussion  of  the 
different  methods  proposed,  or  of  the  possibiUty  of  stabilizing 
prices  by  any  conceivable  method.  It  must  suffice  to  say  that 
as  yet  no  method  of  general  price  control  has  been  devised 
which  commands  sufficient  support  in  government  circles  to 
secure  a  thoroughgoing  practical  test.  The  method  of  price 
stabilization  that  has  attracted  the  greatest  attention  is  that 
advanced  by  Professor  Irving  Fisher,  and  known  as  the  com- 
pensated or  stabilized  dollar.  Under  this  plan  it  is  proposed 
to  vary  the  weight  of  the  gold  dollar  in  which  prices  are 
expressed,  in  proportion  to  changes  in  the  number  of  monetary 
units,  thereby  preventing  variations  in  the  general  level  of 
prices.'  Among  students  of  money  and  prices  this  method  of 
price  control  has  many  supporters — and  numerous  opponents. 
Another  method  of  price  regulation  hes  in  the  control  of  the 
supply  of  bank  credit  through  the  machinery  set  up  by  the 
Federal  Reserve  System.  This  will  be  briefly  considered  on 
page  753  below. 

The  price  mechanism  is  not  always  a  satisfactory  guide  to  the 
distribution  of  social  energy.  One  of  the  most  difficult  problems 
associated  with  the  pecuniary  system  is  that  of  maintaining 
and  developing,  in  periods  of  rising  prices,  our  basic  "quasi- 
pubUc"  enterprises  such  as  transportation  and  public  utilities. 
In  a  financially  organized  society,  we  rely  upon  price  and  profit 
levels  to  direct  the  flow  of  labor  and  capital  into  the  various 
Unes  of  enterprise.  But  owing  to  a  fear  of  exploitation  by 
private  interests  in  naturally  monopolistic  fields  of  enterprise, 
society  has  assumed  the  control  of  rates  (prices)  in  such  indus- 
tries, with  the  inevitable  result  that  in  periods  of  rising  prices 
these  enterprises  are  unable  to  compete  with  uncontrolled 
industries  for  the  necessary  supply  of  labor  and  capital  with 

»See  Irving  Fisher,  The  Stabilized  Dollar. 


FINANCE  AND  ECONOMIC  ORGANIZATION  747 

which  to  maintain  and  develop  their  properties.  We  rely  upon 
price  and  profit  levels  to  guide  industrial  development  and  then 
refuse  to  allow  the  mechanism  to  function  freely  in  precisely 
those  fields  of  enterprise  which  are  of  greatest  social  importance. 
Here  is  an  inherent  weakness  in  the  system  of  distributing 
social  energy  through  pecuniary  means.  True,  we  are  coming 
to  recognize  that  rates  must  be  raised,  in  order  to  permit  such 
industries  to  live;  but  as  yet  the  practical  difficulties  in  the 
way  of  a  ready  adjustment  of  rates  to  rising  prices  are  such 
that  quasi-pubhc  enterprises  are  tremendously  handicapped,  to 
the  great  detriment  of  the  entire  economic  system.  This 
analysis,  moreover,  applies  almost  equally  well  to  government 
service  and  the  public  school  system,  where  advances  in  salaries 
are  dependent  upon  increases  in  taxation  which  can  be  secured 
only  very  tardily  at  the  best.  We  have  also  noted  the  inherent 
weakness  of  the  financial  mechanism  in  effecting  a  rapid  and 
thoroughgoing  mobilization  of  economic  resources  for  the 
purposes  of  war.' 

One  is  tempted  at  this  place  to  enter  into  a  general  discus- 
sion of  the  adequacy  of  the  price  and  profit  mechanism  as  a 
means  of  effecting  the  distribution  of  social  energy,  under 
conditions  where  it  is  allowed  free  play — subject  to  no  govern- 
mental interference  in  the  form  of  price  or  rate  control.  Does 
the  price-and-profit  method  of  industrial  motivation  always 
promote  social  welfare?  Does  it,  for  example,  have  as  its 
goal  "necessities  for  all  before  luxuries  for  any"?  Does  it 
not  often  lead  to  the  rapid  and  visionless  exploitation  of  natural 
resources  ?  Is  it  not  in  fact  essentially  a  system  where  rela- 
tively short-run  pecuniary  considerations  govern,  whereas  the 
promotion  of  national  welfare  requires  essentially  a  long-run 
point  of  view?  Since  these  considerations  are  not,  however, 
exclusively  of  a  financial  nature,  but  involve  the  whole  ques- 
tion of  individual  initiative,  private  property,  free  competi- 
tion, etc.,  they  do  not  properly  come  within  the  scope  of  the 
present  treatise,  which  is  concerned  only  with  the  pecuniary 
aspects  of  the  modern  economic  system, 

*  See  pp.  45-48  above. 


748         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

n.  THE  rOle  of  finance  in  modern 

ECONOMIC  ORGANIZATION 

One  of  the  most  striking  features  of  the  modern  economic 
world  is  the  institution  of  credit.  Whether  in  commerce, 
industry,  or  agriculture,  modern  business  enterprise  is  almost 
always  dependent  upon  the  use  of  borrowed  funds;  and,  as  we 
have  seen,  the  numerous  financial  agencies  and  institutions  of 
the  present  time  have  been  developed  largely  for  the  purpose 
of  facilitating  the  raising  of  the  fixed  and  working  capital 
required  in  the  conduct  of  business.  The  evolution  of  this 
"credit  society,"  as  it  is  often  called,  has  resulted  in  creating  an 
economic  organization  in  which  all  business  enterprises,  all 
institutions,  and  all  individuals  share  in  a  common  dependence 
upon  the  smooth  working  of  an  intricate  and  exceedingly 
sensitive  financial  mechanism,  over  which  they  have  little 
control,  either  individually  or  collectively.'  The  chart  on  page 
136  indicates  that  the  borrowing  corporations  at  the  top  are 
dependent  for  the  fixed  capital  required  in  developing  their 
properties  upon  the  supply  of  funds  procurable  in  a  general 
investment  market,  which,  in  last  analysis,  means  upon  the 
diversion  of  individual  incomes  from  consumptive  spending  to 
the  purchase  of  securities,  either  directly  or  through  the  inter- 
mediation of  savings  institutions.  (The  role  that  commercial 
banks  play  in  the  investment  market  should,  however,  be 
recalled  in  this  connection.)  Similarly,  for  working  capital,  they 
are  dependent  upon  the  commercial  credit  market,  that  is  to 
say,  upon  the  commercial  banking  system  and  the  supply  of 
Uquid  capital  which  it  possesses. 

Under  ordinary  circumstances,  and  considered  individually, 
no  business  enterprise,  which  is  in  a  sound  financial  position, 
need  find  this  dependence  a  cause  of  any  concern.  But  col- 
lectively speaking,  borrowing  corporations  not  infrequently  find 
that  the  supply  of  credit  both  for  fixed  and  for  working  capital 
purposes  is  inadequate  to  their  requirements — either  because 

'Bankers  are  excluded  here,  to  be  considered  in  the  section  which 
follows. 


FINANCE  AND  ECONOMIC  ORGANIZATION  749 

of  an  insufl5cient  volume  of  saving,  an  outflow  of  reserve  funds 
from  the  country,  an  increase  in  the  volume  of  business  beyond 
the  credit  capacity  of  the  banks,  or  a  rising  price  level  which 
requires  a  steadily  expanding  volume  of  liquid  capital  with 
which  to  effect  a  given  volume  of  production.  Whatever  the 
particular  cause,  every  individual  business  finds  its  productive 
operations  seriously  hampered,  and  society  as  a  whole  suffers 
in  consequence  of  restricted  output.  Moreover,  because  of  the 
phenomena  of  the  business  cycle,  itself  a  result  of  the  evolution 
of  the  credit  system,  there  are  times,  as  we  have  seen,  when 
the  entire  business  and  credit  structure  is  completely  disrupted, 
resulting  in  unemployment  for  millions  of  persons  and  financial 
failure  for  thousands  of  business  concerns  whose  only  fault  lies 
in  being  unfortunately  placed  in  the  economic  system. 

Business  corporations  and  individual  workers  are  dependent 
upon  the  smooth  functioning  of  the  credit  system  not  merely 
for  the  regularity  of  profits  and  wages;  as  investors  in  corporate 
securities  they  are  also  dependent  upon  it  for  the  safety  of  their 
savings  and  the  perpetuity  of  interest  payments.  As  the  chart 
on  page  218  indicates,  literally  almost  every  individual  and 
every  institution  is,  under  modern  conditions,  vitally  interested 
as  an  investor  in  the  efficient  working  of  the  financial  system. 
Corporations  and  other  business  concerns  are  obliged  to  invest 
reserve  and  similar  funds  in  the  securities  of  other  corporations ; 
banks,  insurance  companies,  clubs,  educational  and  charitable 
institutions,  labor  union  organizations,  and  trust  estates — all 
are  of  necessity  holders  of  corporate  securities;  and,  under 
a  pecuniary  order,  the  individual  laborer  or  salaried  man  can 
effect  the  savings  required  for  sickness  and  age  only  through 
the  investment  of  pecuniary  income,  directly  or  indirectly,  in 
the  bonds  and  shares  of  corporate  enterprises.  To  a  greater  or 
less  degree  all  classes  are  thus  mutually  dependent  upon  the 
efficient  functioning  of  the  pecuniary  mechanism;  all  have  a  stake 
in  the  promotion  of  financial  soUdarity  and  financial  prosperity; 
and,  what  is  more  significant,  all  have  vested  pecuniary  interests 
in  the  maintenance  of  the  existing  economic  system. 


7  so         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

in.    THE  DOMINANT  POSITION  OF  THE 
FINANCIER 

The  evolution  of  the  credit  system  has  also  resulted  in 
placing  those  who  control  the  distribution  of  liquid  capital  in 
a  position  of  supreme  importance  in  the  modern  scheme  of 
things;  it  has  given  rise  to  "a  class  of  pecuniary  experts 
whose  business  is  the  strategic  management  of  the  interstitial 
relations  of  the  system."  We  have  already  indicated,  in  the 
chapters  on  the  marketing  of  corporate  securities,  that  there 
is  lodged  in  the  hands  of  investment  bankers  a  substantial 
measure  of  control  in  distributing  the  flow  of  labor  and  capital 
among  the  various  divisions  of  industry  and  among  the  different 
establishments  within  any  given  field  of  enterprise.  .  We  shall 
presently  have  more  to  say  with  reference  to  this  control  under 
conditions  of  large  scale  and  highly  concentrated  finance  and 
business  such  as  exist  at  the  present  time;  but  before  entering 
upon  the  discussion  it  is  necessary  to  indicate,  more  precisely 
than  has  been  done  in  preceding  chapters,  the  r61e  that  the 
commercial  banker  plays  in  guiding  and  controlling  industrial 
activity. 

In  the  making  of  loans  for  working  capital  purposes  com- 
mercial bankers,  as  we  have  seen,  form  their  judgment  as  to 
the  safety  of  the  loan  on  the  basis  of  personal  knowledge  of 
the  applicant's  moral  integrity  and  of  his  financial  ability  and 
resources,  as  revealed  in  a  financial  statement  of  condition.  If, 
in  the  judgment  of  the  commercial  bankers,  a  particular  bor- 
rower in  a  given  line  of  industry  is  not  entitled  to  credit,  there 
is  httle  chance  of  his  survival  in  competition  with  others  whose 
credit  standing  is  unimpaired.  Since  the  possession  of  adequate 
working  capital  is  quite  as  indispensable  as  the  possession  of 
fixed  capital,  the  commercial  banker  thus  in  a  sense  holds  the 
veto  power  over  the  decision  of  the  investment  banker,  even 
as  the  investment  banker  holds  the  veto  power  over  the  decision 
of  the  manager  of  a  corporation  which  is  seeking  to  raise  fixed 
capital.  And  certainly,  it  will  be  observed,  the  dependence  of 
almost  every  business  upon  both  investment  and  commercial 


FINANCE  AND  ECONOMIC  ORGANIZATION  751 

bankers  results  in  giving  to  these  financiers  a  preponderant 
influence  in  the  control  of  the  development  of  industry. 

The  influence  of  the  commercial  bankers  is  of  particular 
importance  by  virtue  of  the  fact  that  their  relations  with 
borrowers  are  usually  continuous,  rather  than  intermittent. 
Since  they  are  called  upon  to  furnish  credit  year  in  and  year 
out,  it  is  necessary  for  the  commercial  bankers  to  scrutinize 
continuously  the  financial  status  of  their  customers;  accord- 
ingly, they  are  privy  to  the  most  intimate  affairs  of  producers, 
manufacturers,  and  distributors  of  goods,  as  well  as  of  those 
who  are  engaged  in  financial  or  speculative  activities.  They 
find  it  expedient  to  give  advice  and  counsel  in  the  formation 
of  business  poUcies;  and  because  of  their  control  of  the  requisite 
financial  resources,  they  are  commonly  in  a  position  to  exercise 
a  restraining  influence.  Moreover,  when  occasion  arises  they 
can  withhold  credit  and  compel  a  financial  reorganization  of  a 
business  and  a  change  of  management  and  policies.  Whether 
such  financial  power  will  be  exercised  for  good  or  for  ill — with 
or  without  sinister  intent — obviously  depends  upon  the  per- 
sonnel of  the  banking  profession.  On  the  whole,  there  has  been 
remarkably  little  legitimate  criticism  leveled  against  the  control 
over  commerce  and  industry  by  commercial  bankers.  One  of 
the  oldest  of  business  professions,  the  banking  fraternity,  has 
developed  a  tradition  that  it  is  a  duty  to  exercise  the  great 
power  which  it  possesses  without  fear  or  favor  and  in  such 
ways  as  to  promote  the  development  of  sound  business  enter- 
prise. Everyone  with  business  experience  can  of  course  cite 
instances  where  this  tradition  has  not  been  realized;  but  such 
cases  are  undoubtedly  the  exception  rather  than  the  rule.^ 

The  control  of  credit  by  individual  bankers  proved  inadequate 
for  the  requirements  of  the  modern  business  cycle.  The  analysis 
in  chapters  xxiii  and  xxiv  revealed  a  very  striking  weakness  in 
the  system  of  banking  control  over  business.  With  the  evo- 
lution of  our  delicately  adjusted  interdependent  credit  system — 
national  and  international  in  scope — it  became  impossible  for 

^But  see  pages  764-65. 


752         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

bankers,  acting  as  individuals,  to  exercise  the  degree  of  control 
over  general  business  conditions  that  was  required.  While  any 
particular  banker  might  withhold  or  extend  credit  to  his  indi- 
vidual customers  in  accordance  with  their  respective  moral  and 
financial  merits,  under  our  decentralized  banking  system  bankers 
in  general  could  not,  however,  control  business  in  general,  in 
accordance  with  the  requirements  of  the  various  stages  of  the 
business  cycle.  The  result,  as  we  have  seen,  was  a  periodic 
disruption  of  the  entire  credit  structure.  The  supersedure  of 
this  decentraHzed  method  of  banking  control  by  a  system  of 
government  supervision,  vested  in  the  federal  Reserve  Board, 
has  resulted  in  materially  lessening  the  functions  of  the  private 
financier  in  the  control  of  business,  and  has  brought  into 
existence  a  body  of  what  may  be  called  public  financiers,  whose 
influence  over  economic  affairs  is  of  far-reaching  importance. 

Extraordinary  economic  power  has  been  vested  in  the  Federal 
Reserve  Board.  It  is  the  duty  of  the  Federal  Reserve  Board 
and  of  the  directors  of  the  Federal  Reserve  banks  to  so  control 
the  operation  of  economic  and  financial  forces  in  connection 
with  the  business  cycle  that  financial  panics  may  be  eliminated 
and  the  extent  of  the  fluctuations  in  business  activity  may  be 
substantially  lessened.  To  this  end  there  has  been  lodged  in 
their  hands  a  control  over  interest  rates  and  over  the  supply  of 
credit  that  enables  them  to  wield  a  tremendous  influence  over 
general  business  conditions.  It  should  be  recalled  that  by 
virtue  of  the  dominant  place  that  commercial  banking  occupies 
in  the  entire  financial  and  business  structure,  the  control  of  the 
Federal  Reserve  Board  extends  to  the  utmost  confines  of  the 
economic  organization.  Concretely,  the  fixing  of  very  high 
interest  rates  and  the  restriction  of  credit  can  precipitate  a  fall 
in  general  prices,  a  great  contraction  of  the  volume  of  business 
and  consequent  decUne  of  profits,  a  reduction  of  wages,  and  a 
great  increase  in  the  volume  of  unemployment,  together  with 
a  collapse  of  stock-market  values,  a  limitation  of  the  activities 
of  underwriters  and  bond  distributors,  and  an  unsettling  of  the 
entire  credit  system;  and  conversely,  by  a  policy  of  very  low 
discount  rates,  together  with  the  release  of  all  restrictions 


FINANCE  AND  ECONOMIC  ORGANIZATION  753 

on  credit  extension,  as  a  means  ot  encouraging  busmess  opti- 
mism, the  Federal  Reserve  Board  is  frequently — though  not 
under  all  circumstances — in  a  position  to  stimulate  business 
activity,  increase  profits  and  wages,  give  steady  employment 
to  all  who  care  to  work,  and  facilitate  the  marketing  of  invest- 
ment securities  and  the  financing  of  new  business  enterprises. 
Because  of  the  nature  of  the  modern  pecuniary  and  credit 
system,  as  revealed  in  the  phenomena  of  the  business  cycle, 
such  a  stimulation  of  business  activity,  however,  always  eventu- 
ally leads  to  rising  prices,  unaccompanied  by  a  continuous 
increase  in  the  output  of  wealth,  and  culminates  in  an  economic 
crisis,  followed  by  an  era  of  liquidation  and  a  readjustment  of 
prices  and  business  conditions  generally.  Such  enormous  power 
and  so  great  a  responsibility  have  never  before,  in  this  country, 
been  conferred  upon  any  group  of  individuals. 

The  measure  of  control  that  may  conceivably  be  exercised 
by  the  Federal  Reserve  Board  in  stabiUzing  prices  and  in 
minimizing  the  ebb  and  flow  of  business  activity  is  open  to  a 
great  deal  of  question.  The  experience  of  European  countries, 
where  the  directors  of  the  Central  banks  have  long  held  a  posi- 
tion in  the  European  financial  and  business  world  similar  to  that 
occupied  by  the  Federal  Reserve  Board  in  the  United  States, 
throws  no  little  light  on  the  problem.  In  brief,  it  has  been 
possible  for  the  European  Central  bank  directors  to  prevent 
acute  financial  panics  and  to  control  in  some  degree  the  extent 
of  the  upward  swing  of  the  business  cycle.  But  they  have  by 
no  means  been  able  to  control  prices,  or  to  eliminate  or  even 
greatly  reduce  the  ebb  and  flow  of  business  activity,  and  thus 
to  usher  in  the  "normal"  or  static  state  which  is  at  once  the 
point  of  departure  and  the  goal  of  classical  economic  analysis. 
In  the  face  of  the  financial  requirements  of  war,  moreover,  the 
European  Central  banks  as  well  as  our  own  Federal  Reserve 
System,  have  found  it  practically  impossible  to  prevent  a  very 
general  disruption  of  the  entire  price  and  credit  system. 

While  the  centralization  of  financial  control  in  the  hands  of 
the  Federal  Reserve  Board  will  likewise  doubtless  result  in 
preventing  panics  and  in  lessening  somewhat  the  oscillation  of 


754         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

business,  judging  from  experience  there  is  little  ground  foi 
hope  that  it  can  give  us  either  stable  prices  or  continuous 
prosperity.  The  extent  of  the  influence  that  can  thus  be 
exerted  wiU,  moreover,  largely  depend  upon  the  wisdom  and 
impartiaHty  with  which  the  vast  power  that  has  been 
placed  in  the  hands  of  the  Federal  Reserve  Board  is  utilized; 
and  this  in  turn  will  depend  upon  the  degree  of  knowledge 
which  its  members  possess  of  the  working  of  the  complex 
economic  forces  that  operate  in  the  modern  capitahstic  and 
industrial  system,  as  also  upon  their  freedom  from  the  influence 
of  either  personal  or  political  considerations. 

IV.     INTERNATIONAL  ASPECTS  OF  FINANCIAL 
ORGANIZATION 

Of  necessity  this  .volume  has  been  largely  devoted  to  a 
discussion  of  the  financial  organization  of  society  as  revealed 
in  the  United  States  of  America.  While  here  and  there  reference 
has  been  made  to  the  financial  institutions  of  other  nations, 
there  has  been  no  attempt  to  make  a  comparative  study  of  the 
financial  systems  of  different  countries,  nor  has  it  been  an 
essential  part  of  our  task  to  indicate  the  relationship  of  the 
financial  system  to  the  world-aspects  of  modern  economic 
organization.  At  a  few  places  in  the  treatise,  however,  we  have 
necessarily  been  drawn  into  a  discussion  of  certain  phases  of 
the  system  of  international  finance.  In  the  chapter  on  the 
foreign  exchanges  we  saw  how  international  commercial  and 
financial  obligations  are  largely  canceled  through  the  use  of 
bills  of  exchange;  how  the  world-supply  of  metallic  currency 
is  ordinarily  distributed  among  the  various  nations  of  the 
world  in  rough  accordance  with  their  relative  needs;  and,  how 
the  international  financial  equilibrium  is  maintained  through 
the  operation  of  the  foreign-exchange  mechanism.  And  in 
chapter  xvi  we  considered  some  of  the  economic  and  social 
consequences  to  the  world  as  a  whole  of  the  overturning  of  the 
international  financial  equilibrium  and  the  dislocation  of  the 
international  financial  structure  that  were  caused  by  the 
requirements  of  the  Great  War. 


FINANCE  AND  ECONOMIC  ORGANIZATION  755 

We  have  also  seen  in  various  connections  that  the  system 
of  interdependent  credit  relations  is  now  world-wide  in  scope. 
When  the  great  speculative  mania  in  the  Argentine  in  the 
decade  of  the  eighties,  accompanied  by  the  issue  of  vast  quan- 
tities of  irredeemable  paper  currency,  collapsed  in  1890  it 
resulted  in  the  failure  of  one  of  the  greatest  international  bank- 
ing houses  of  England,  all  but  precipitated  a  general  financial 
panic  in  Europe,  and  led  to  a  very  serious  unsettling  of  American 
financial  conditions.  Similarly,  financial  difficulties  in  Japan 
and  Egypt  in  1906  contributed  to  the  forces  that  were  bringing 
on  the  American  panic  of  1907,  while  the  repercussions  of  this 
panic  in  the  United  States  were  felt  in  every  market  of  the 
world.  In  a  word,  business  cycles  are  world-phenomena  and 
the  modern  financial  structure  is  essentially  international  in  its 
scope.  The  world  has  reached  a  point  in  the  development  of 
its  organized  economic  activities  where  national  boundaries  are 
of  relatively  little  significance,  notwithstanding  the  numerous 
economic  barriers  that  have  been  erected  by  political  states. 

A  very  interesting  result  of  the  development  of  an  inter- 
national financial  structure  was  strikingly  suggested  ten  years 
ago  by  Normal  Angell  in  The  Great  Illusion.  The  illusion,  as 
Mr.  Angell  saw  it,  was  the  belief  that  modern  warfare  pays, 
and  he  proceeded  to  demonstrate  that  in  consequence  of  the 
interlocking  financial  systems  of  modem  nations,  even  a  success- 
ful war  would  inevitably  result  in  economic  loss  to  the  victor 
as  well  as  to  the  vanquished.  While  it  may  be  true  that  the 
victor,  notwithstanding  certain  absolute  losses,  may  possibly 
emerge  in  a  relatively  stronger  position  than  the  vanquished, 
the  present  chaotic  conditions  in  aU  the  European  belHgerent 
nations  and  the  practical  difficulties  in  the  way  of  the  settlement 
of  international  financial  obligations  and  indemnities  constitute 
fairly  conclusive  proof  that  modern  war  is  bad  business  for  all 
concerned.'     Germany  can  pay  indemnities  to  France,  in  the 

^  'It  needs  reiterating  that  Mr.  Angell  did  not  contend,  as  so  many 
of  his  critics  state,  that  war  was  no  longer  possible;  he  merely  argued 
that  it  did  not  pay,  and  he  believed  that  if  knowledge  of  this  fact  were 
disseminated  it  would  constitute  an  important  barrier  against  international 
conflict. 


756         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

main,  only  by  the  export  of  goods  to  France;  but  French 
industry  is  unwilling  to  submit  to  this  competition  in  its  own 
markets,  or  even  in  foreign  markets  where  conceivably  Germany 
might  be  able  to  pay  by  roundabout  methods.  In  similar 
fashion,  Europe  can  pay  her  large  war  indebtedness  to  the 
United  States  only  by  diminishing  her  imports  from,  and 
increasing  her  exports  to,  this  country.  Are  the  American 
people  willing  that  these  obligations  shall  be  paid?  The 
present  attempt  to  organize  financing  corporations  for  main- 
taining and  increasing  our  foreign  exports,  and  the  growing 
agitation  for  increasing  tariff  rates  in  order  to  protect  American 
industry  from  the  reviving  competition  of  Europe  afford  suffi- 
cient answer. 

The  growing  interdependence  of  the  financial  systems  of 
different  countries  and  the  development  of  an  international 
financial  structure  give  rise  to  the  suggestion  that  if  the  finan- 
cial system  is  effectively  to  perform  its  functions  in  assisting 
and  regulating  the  modern  economic  organization,  some  system 
of  international  control  must  ultimately  be  devised.  It  may  be 
argued  that  just  as  the  growth  of  a  national,  as  distinguished 
from  a  local,  basis  of  economic  organization  destroyed  the 
efficacy  of  local  and  state  control  of  finance  and  business  and 
required  the  development  of  a  system  of  national  supervision, 
so  the  evolution  of  a  world  economic  and  financial  system 
requires  the  creation  of  an  international  supervisory  board  or 
commission.  It  required,  in  all  countries,  the  greater  part  ot 
a  century  following  the  development  of  a  national  economy 
to  evolve  a  system  of  financial  control  that  was  of  commensurate 
scope  and  power.  Who  can  say  what  another  century  may 
not  bring  forth  in  the  way  of  an  international  financial  organi- 
zation ? 

V.    THE  CONCENTRATION  OF  FINANCIAL 
POWER 

One  of  the  most  striking  features  of  the  modern  economic 
and  financial  systems  has  throughout  the  discussion  of  the  pre- 
ceding chapters  been  neglected,  namely,  the  development  of 


FINANCE  AND  ECONOMIC  ORGANIZATION  757 

huge  financial  institutions  and  consolidations  akin  to  those  in 
the  field  of  commerce  and  industry.  So  significant  is  this 
development  in  view  of  the  potential  power  and  influence  over 
the  general  economic  organization  that  it  may  give  to  the 
directors  of  the  financial  system,  that  it  merits  special  con- 
sideration in  this  concluding  chapter.  The  discussion  will,  it 
is  believed,  give  added  point  to  the  problems  of  national  and 
international  control  outlined  in  the  preceding  section. 

There  was  presented  in  the  chapter  on  "The  Corporation 
as  a  Capital-Raising  Device,"  a  general  outline  of  the  various 
stages  in  our  industrial  development  since  the  Middle  Ages. 
It  will  be  recalled  that  the  last  stage  of  this  industrial  evolution, 
beginning  shortly  before  the  end  of  the  nineteenth  century, 
was  marked  by  a  phenomenal  consolidation  movement  in 
commerce  and  industry  and  the  emergence  of  what  is  commonly 
designated  as  an  era  of  monopoly  or  trust  control.  Now  the 
development  of  this  large-scale  corporate  enterprise,  together 
with  the  uniting  of  hitherto  independent  concerns  into  gigantic 
combinations  in  the  field  of  transportation,  manufacturing  and 
commerce,  were  necessarily  paralleled  in  the  field  both  of 
commercial  and  investment  banking.  Indeed,  the  two  move- 
ments have  developed  hand  in  hand,  each  having  been  necessary 
to  the  continuance  of  the  other:  the  growth  of  huge  banking 
institutions  made  possible  the  assembling  of  the  capital  required 
by  corporate  consolidations;  and,  conversely,  the  development  of 
giant-scale  corporate  industry  required  and  made  profitable  the 
development  of  financial  institutions  of  commensurate  resources. 

The  concentration  of  financial  resources  was  effected  to 
some  extent  by  the  organization,  de  novo,  of  banking  institutions 
of  very  large  size,  but  more  largely  by  a  process  of  affiliation' 
and  consolidation  of  existing  institutions.  The  period  of  most 
rapid  evolution  in  this  direction  coincided  with  the  era  of  indus- 
trial combination,  namely,  the  fifteen  years  from  1897  to  1912.* 

'  For  a  statement  with  reference  to  the  affiliation  of  commercial  banks 
and  trust  companies  see  p.  729  above. 

*  The  last  two  years  have  witnessed  a  renewal  of  the  movement  in  the 
United  States;  and  post-war  financial  concentration  has  been  especially 
marked  in  England. 


758         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

The  total  number  of  banks  in  New  York  decreased  from  130 
to  120  during  the  ten  years  from  1901  to  1911.  In  1896  the 
largest  bank  in  New  York  City  had  less  than  30  millions  of 
deposits;  by  191 1  there  were  six  New  York  institutions  with 
more  than  100  millions  each;  while  in  the  five  years  from  1907 
to  191 2,  one  New  York  trust  company  increased  its  deposits 
from  20  to  166  millions.'  In  the  year  191 1  there  were  ten 
banks  in  the  United  States  with  deposits  in  excess  of  75  million 
dollars  each,  seven  of  them  located  in  New  York  and  two  in 
Chicago, 

A  factor  of  no  little  importance  in  furthering  the  movement 
toward  financial  concentration,  particularly  in  the  years  after 
1907,  was  the  desire  to  strengthen  the  financial  structure  and 
to  render  less  abortive  the  efforts  of  the  banks  to  co-operate 
in  future  emergencies  for  the  control  of  financial  crises.  In  the 
words  of  Noyes: 

The  bank  suspensions,  in  New  York  particularly,  dvirJng  the 
panic  of  1907,  emphasized  the  dangers  created  for  the  community 
at  large  by  weak  or  ill-managed  institutions  in  a  central  money 
market.  Finally,  the  incidents  of  that  panic — including  the  tem- 
porary breakdown  of  credit  facilities,  the  distrust  by  banks  of  one 
another,  the  lack  of  quick  and  effective  co-operation  to  relieve  the 
crisis — taught  the  supreme  necessity  for  a  banking  power  strong 
enough  to  meet  the  worst  emergency.  Concentration  of  the  banking 
resources  at  the  country's  money  center  is,  in  the  absence  of  a  central 
institution  such  as  the  Bank  of  England,  the  only  means  of  control- 
ling, promptly  and  effectively,  a  crisis  of  that  kind.' 

A  similar  consolidation  of  banking  institutions  has  occurred 
in  other  countries,  particularly  in  Germany,  where  it  has  been 
carried  much  farther  than  in  the  United  States.  The  move- 
ment in  Germany  is  attributable  to  the  same  forces  that  were 
operating  in  the  United  States,  plus  the  added  one  of  govern- 
mental support  as  a  means  of  furthering  Germany's  financial 
and  trading  operations  overseas.    The  financial  crisis  of  1901 

'  Some  allowance  should  be  made  in  these  figures  of  growth,  for  the 
30  per  cent  increase  in  the  price  level  between  1900  and  191 1. 
'  Alexander  D.  Noyes,  Atlantic  Monthly,  CXI  (1913),  653. 


FINANCE  AND  ECONOMIC  ORGANIZATION  759 

was  a  particularly  potent  factor  in  promoting  the  consolidation 
of  German  banks,  a  large  number  of  small  banks  being  rescued, 
as  it  were,  from  the  financial  rocks  on  which  they  found  them- 
selves by  incorporation  into  or  affiliation  with  the  oowerful 
institutions  that  survived.  Within  five  years  the  Deutsche 
Bank  absorbed  forty-nine  smaller  banks,  the  Dresdner  Bank 
forty-one,  and  the  Discontogesellschaft  twenty-eight.  Of  such 
unparalleled  magnitude  has  been  this  German  financial  con- 
centration and  of  such  importance  is  it  to  an  adequate  appre- 
ciation of  the  possibilities  of  control  of  all  economic  life  which 
under  favoring  conditions  may  be  vested  in  a  relatively  small 
group  of  financial  directors,  that  a  fuller  statement  is  warranted 
before  returning  to  a  consideration  of  the  results  of  the  financial 
concentration  movement  in  the  United  States.  According  to 
Hauser: 

In  some  cases  the  great  banks  simply  annexed  those  institutions 
which  were  previously  autonomous,  and  took  over  the  business  of 
menaced  establishments,  converting  them  into  branches.  More  often 
they  allowed  them  to  continue  in  existence  for  form's  sake,  contenting 
themselves  with  financing  them,  or  perhaps  acquiring  a  sufficiently 
large  number  of  shares  in  these  concerns  to  assume  their  effective 
control.  Sometimes,  also,  in  order  to  study  appearances  still  more, 
an  exchange  of  shares  was  the  medium  employed;  the  absorbing 
bank  and  the  bank  absorbed  reciprocally  delegated  their  directors 
from  one  board  to  the  other. 

With  these  banks  they  formed  groups.  As  the  banks  thus 
absorbed  or  mediatised  had  themselves  in  most  cases  arrived  at  a 
certain  stage  of  concentration,  as  they  had  their  branches  and 
daughter  institutions,  it  followed  that  groups  of  groups,  formidable 
unions,  were  formed.  When  the  Deutsche  Bank  by  means  of  an 
exchange  of  shares  made  itself  master  of  the  Bergisch-Markische 
Bank  of  Elberfeld  in  1897,  the  latter  had  already  thirteen  branches, 
having  successively  absorbed  half  a  score  of  Rhenish  banks.  A 
whole  block  of  concerns  thus  passed  into  the  control  of  the  great 
Berlin  bank  at  one  stroke. 

To  achieve  transformations  of  this  magnitude  enormous  aug- 
mentations of  capital  were  necessary;  that  of  the  Deutsche  Bank 
rose  in  two  years  from  £1,000,000  to  £9,000,000  and  in  the  following 
year  to  £10,000,000.    This  total  was  also  in  191 1  that  of  the  Dresdner 


76o        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

and  the  Disconto.  The  Darmstadter  capital  reached  £8,000,000,  the 
Schaafhausen  £7,250,000,  the  BerHner  Handelsgesellschaft  £5,500,000 
— a  total  of  more  than  £50,000,000  for  the  six  institutions.  Some 
provincial  banks,  the  Rheinisch-Westfahsche  Discontogesellschaft 
and  the  Rheinische  Credit  Bank,  each  with  £4,750,000,  exceeded  the 
other  metropohtan  banks  such  as  the  Nationalbank,  the  Commerz 
and  Disconto  Bank,  etc.  Banks  whose  capital  in  each  case  exceeded 
£3,000,000  represented  a  total  capital  of  £87,250,000. 

But  side  by  side  with  the  actual  power  of  each  bank,  it  is  neces- 
sary to  consider  that  of  the  group  which  it  directs.  By  the  absorp- 
tion or  the  affiUation  of  the  Bergisch-Markische,  the  Schlesischer 
Bankverein  of  Breslau,  the  Hannoversche  Bank,  the  Mecklenburger 
Hypotheken  and  Wechselbank,  and  the  Essener  Creditanstalt,  the 
Deutsche  Bank  has  attained  the  position  of  controlling  in  reality  a 
total  capital  of  £34,550,000,  or  of  £48,950,000  with  the  reserves.' 

The  Disconto  (with  the  Norddeutsche  Bank  of  Hamburg,  the 
AUgemein-Deutscher  Creditanstalt  of  Leipzig,  the  Barmer  Bank- 
verein, the  Suddeutsche  Discontogesellschaft  of  Mannheim,  and  the 
Bayerische  Disconto  and  Wechslerbank  of  Nuremberg)  controls 
£25,200,000 — with  reserves  £33,100,000.  The  Dresdner  controls  the 
Markische  Bank  of  Bochum,  the  Rheinische  of  Essen,  and  the  Mul- 
heimer  Bank,  £12,650,000  and  £16,150,000.  The  Darmstadter 
represents  £10,950,000  and  £13,000,000;  the  Schaafhausen  (principal 
satellite  the  Mittelrheinische  Bank  of  Coblenz)  £8,600,000  and 
£10,450,000.  In  all,  the  share  capital  and  reserves  of  these  groups 
represent  a  total  of.£i3 7,500,000. 

At  times  banks  pass  from  one  group  to  another,  for  there  exists 
among  the  controlling  houses  of  the  banking  groups  a  spirit  of  emu- 
lation and  rivalry  which  drives  them  to  absorb  as  many  concerns 
as  possible.  It  was  in  consequence  of  a  struggle  between  the 
Deutsche  Bank  and  the  Dresdner  for  the  domination  of  Westphalian 
industry  that  the  former  absorbed  the  Bergisch-Markische.  The 
Dresdner  in  its  turn  nearly  absorbed  the  ancient  Schaafhausen 
Bank;  and  on  the  eve  of  war  the  Disconto  was  trjdng  to  make 
similar  conquests. 

By  the  side  of  these  rivalries  we  find  ententes.  The  great  banks 
sometimes  form  among  themselves  "  Interessen-gemeinschaf ten" — 
communities  of  interest — "species  of  banking  cartels  which  con- 
centrate formidable  amounts  of  capital  to  one  definite  activity" — 

'  "Reserves"  here  means  surplus  and  undivided  profits. 


FINANCE  AND  ECONOMIC  ORGANIZATION  761 

maybe  for  the  exploitation  of  a  particular  industry,  or  perhaps  for 
the  creation  and  the  management  of  a  secondary  bank.  At  times 
also  this  community  of  interest  unites  two  banks  of  secondary  rank. 
Thus  we  read  in  the  financial  announcements  in  the  German  news- 
papers: "Interessen  gemeinschaft:  Rheinische  Creditbank  Mann- 
heim— Pfalzische  Bank,  Ludwigs-hafen" — not  a  "consortium"  for 
a  pre-determined  transaction,  but  a  permanent  alliance.'' 

The  extent  of  financial  concentration  and  the  nature  of  the 
intricate  interrelations  of  finance  and  business  that  have  de- 
veloped in  the  United  States  were  disclosed  by  the  Pujo  Investi- 
gation of  19 1 2.*    It  was  shown  that 

eighteen  selected  financial  institutions,  namely,  J.  P.  Morgan  &  Co., 
New  York;  First  National  Bank,  New  York;  Guaranty  Trust  Co., 
New  York;  Bankers  Trust  Co.,  New  York;  National  City  Bank, 
New  York;  Kuhn,  Loeb  &  Co.,  New  York;  National  Bank  of 
Commerce,  New  York;  Hanover  National  Bank,  New  York;  Chase 
National  Bank,  New  York;  Astor  Trust  Co.,  New  York;  New 
York  Trust  Co.,  New  York;  Blair  &  Co.,  New  York;  Speyer  &  Co., 
New  York;  Continental  &  Commercial  National  Bank,  Chicago; 
First  National  Bank,  Chicago;  Illinois  Trust  &  Savings  Bank, 
Chicago;  Kidder,  Peabody  &  Co.,  Boston  and  New  York;  and 
Lee,  Higginson  &  Co.,  Boston  and  New  York,  were  affiliated 
through  a  system  of  interlocking  directorates  with  banks,  trust 
companies,  transportation  systems,  public  utility  companies,  and 
trading  corporations.  In  the  aggregate  they  held  385  directorships  in 
41  banks  and  trust  companies  having  total  resources  of  $3,832,000,000 
and  total  deposits  of  $2,834,000,000;  50  directorships  in  11  insiurance 
companies  having  total  assets  of  $2,646,000,000;  155  directorships 
in  31  railroad  systems  having  a  total  capitalization  of  $12,193,000,000 
and  a  total  mileage  of  163,200;  6  directorships  in  2  express  companies 
and  4  directorships  in  i  steamship  company  with  a  combined  capital 
of  $245,000,000  and  gross  income  of  $97,000,000;  98  directorships  in 
28  producing  and  trading  corporations  having  a  total  capitalization 
of  $3,583,000,000  and  total  gross  annual  earnings  in  excess  of 
$1,145,000,000;    48  directorships  in  19  public  utih'ty  corporations 

'  Henri  Hauser,  Gerviany's  Commercial  Grip  on  the  World,  pp.  48-50. 

'  Report  of  the  Committee  Appointed  to  Investigate  the  Concentration  oj 
Control  of  Money  and  Credit,  62d  Cong.,  3d  Sess.,  "Money  Trust  Investiga- 
tion: Interlocking  Directorates." 


762         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

having  a  total  capitalization  of  $2,826,000,000  and  total  gross  annual 
earnings  in  excess  of  $428,000,000;  in  all,  746  directorships  in 
134  corporations  having  total  resources  or  capitalization  of 
$25,325,000,000. 

A  smaller  group  of  the  more  powerfvd  institutions,  known  as  the 
inner,  or  primary,  group,  to  wit,  J.  P.  Morgan  &  Co.,  The  First 
National  Bank,  The  National  City  Bank,  The  Guaranty  Trust  Co., 
and  The  Bankers  Trust  Company,  together  have  118  directorships 
in  34  banks  and  trust  companies  having  total  resources  of  $2,679,- 
000,000  and  total  deposits  of  $1,983,000,000;  30  directorships  in  10 
insurance  companies  having  total  assets  of  $2,293,000,000;  105 
directorships  in  32  transportation  systems  having  a  total  capitaliza- 
tion of  $11,784,000,000  and  a  total  mileage  (excluding  express  com- 
panies and  steamship  lines)  of  150,200;  63  directorships  in  24 
producing  and  trading  corporations  having  a  total  capitaUzation  of 
$3,339,000,000;  25  directorships  in  12  public  utility  corporations 
having  a  total  capitalization  of  $2,150,000,000;  in  all,  341  director- 
ships in  112  corporations  having  aggregate  resources  or  capitalization 
of  $22,245,000,000. 

It  will  be  observed  that  some  of  the  financial  institutions 
enumerated  above  originated  as  investment  banking  insti- 
tutions, that  others  began  as  trust  companies,  and  still  others 
as  national  banks;  but  regardless  of  their  original  functions 
or  their  present  designation  as  investment,  commercial,  or 
trust  institutions,  all  are  now  engaged  in  similar  financial 
operations;  all  are  interested  in  underwriting  and  distributing 
investment  securities;  all  maintain  commercial  banking  depart- 
ments and  all  are  affiliated  with  other  financial  institutions  and 
business  corporations.  Here  is  financial  and  business  integra- 
tion in  its  most  highly  developed  form. 

The  affiliation  of  the  smaller  banks  and  bankers  throughout 
•the  country  with  the  inner  groups  and  subgroups  of  the  so- 
called  "money  trust"  is  set  forth  by  the  Pujo  committee  in 
the  following  terms: 

Beyond  these  inner  groups  and  subgroups  are  banks  and  bankers 
throughout  the  country  who  co-operate  with  them  in  underwriting 
or  guaranteeing  the  sale  of  the  securities  offered  to  the  public,  and 
who  also  act  as  distributors  of  such  securities.    It  was  impossible 


FINANCE  AND  ECONOMIC  ORGANIZATION  763 

to  learn  the  identity  of  the  corporations,  owing  to  the  unwiUingness 
of  the  members  of  the  inner  group  to  disclose  the  names  of  their 
underwriters,  but  sufficient  evidence  appears  to  justify  the  state- 
ment that  there  are  at  least  hundreds  of  them  and  that  they  extend 
into  many  of  the  cities  throughout  this  and  foreign  countries. 

The  patronage  thus  proceeding  from  the  inner  group  and  its 
subgroups  is  of  great  value  to  these  banks  and  bankers,  who  are 
thus  tied  by  self-interest  to  the  great  issuing  houses  and  may  be 
regarded  as  a  part  of  this  vast  financial  organization.  Such  patronage 
yields  no  inconsiderable  part  of  the  income  of  these  banks  and  bankers 
without  much  risk  on  account  of  the  facilities  of  the  principal  groups 
for  placing  issues  of  securities  through  their  domination  of  great 
banks  and  trust  companies  and  their  other  domestic  affiliations 
and  their  foreign  connections.  The  underwriting  commissions  on 
issues  made  by  this  inner  group  are  easily  earned  and  do  not  ordi- 
narily involve  the  underwriters  in  the  purchase  of  the  underwritten 
securities.  Their  interest  in  the  transaction  is  generally  adjusted, 
unless  they  choose  to  purchase  part  of  the  securities,  by  the  payment 
to  them  of  a  commission.  There  are,  however,  occasions  on  which 
this  is  not  the  case.  The  underwriters  are  then  required  to  take 
the  securities.  Bankers  and  brokers  are  so  anxious  to  be  permitted 
to  participate  in  these  transactions  under  the  lead  of  the  inner  group 
that  as  a  rule  they  join  when  invited  to  do  so,  regardless  of  their 
approval  of  the  particular  business,  lest  by  refusing  they  should 
thereafter  cease  to  be.  invited. 

In  the  case  of  the  New  York  subway  financing  of  $170,000,000 
of  bonds  by  Messrs.  Morgan  &  Co.  and  their  associate,  Mr.  Davison 
estimated  that  there  were  100  to  125  such  underwriters  who  were 
apparently  glad  to  agree  that  Messrs.  Morgan  &  Co.,  the  First 
National  Bank,  and  the  National  City  Bank  should  receive  3  per 
cent,  equal  to  $5,100,000,  for  forming  this  syndicate,  thus  relieving 
themselves  from  all  liability,  whilst  the  underwriters  assumed  the 
risk  of  what  the  bonds  would  realize  and  of  being  required  to  take 
their  share  of  the  unsold  portion. 

The  possibility  of  competition  between  these  banking  houses 
in  the  purchase  of  securities  is  further  removed  by  the  imderstanding 
between  them  and  others  that  one  will  not  seek,  by  offering  better 
terms,  to  take  away  from  another  a  customer  which  it  has  hereto- 
fore served,  and  by  corollary  of  this,  namely,  that  where  given 
bankers  have  once  satisfactorily  united  in  bringing  out  an  issue  of  a 


764         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

corporation  they  shall  also  unite  in  bringing  out  any  subsequent  issue 
of  the  same  corporation.  This  is  described  as  a  principle  of  banking 
ethics.' 

The  significance  of  this  consolidation  movement  in  the  field 
of  finance  lies  not  so  much  in  the  mere  size  of  the  institutions 
in  question  or  in  the  community  of  interest  that  has  been  estab- 
lished among  them,  as  in  the  control  which  they  may  possibly 
exercise  over  the  industries  with  which  they  are  affiliated, 
directly  and  indirectly.  The  enormous  changes  in  the  eco- 
nomic system  which  were  effected  between  the  years  1897  and 
191 2  constitute  an  industrial  revolution  of  quite  as  far-reaching 
importance  as  those  which  marked  the  breakdown  of  the  old 
handicraft  regime  and  the  emergence  of  the  factory  system. 
So  swift  has  been  the  change  in  the  nature  and  scope  of  indus- 
trial and  financial  enterprise  since  the  turn  of  the  century,  that 
as  yet  we  have  little  understanding  of  its  possible  ultimate 
significance. 

The  extent  of  the  power  that  is  exercised  by  the  great 
German  banking  consolidations  is  stated,  rightly  or  wrongly,  by 
Riesser,  the  foremost  German  writer  on  banking  problems,  as 
follows: 

The  great  banks  are  able  to  elaborate  programmes  for  joint 
action.  United  by  a  kind  of  quasi-contract,,  forming  practically  a 
tacit  syndicate,  they  are  able  to  raise  themselves  above  the  mere 
policy  of  dividends,  to  keep  count  of  interests  both  general  and 
national,  to  adopt  an  industrial  policy,  to  direct  the  placing  of  capital, 
colonial  undertakings  and  the  business  of  exportation,  canals,  navi- 
gation, and  cables.  They  are  able  to  exercise  control  of  the  Press 
and  of  public  opinion,  to  anticipate  crises  and  weaken  their  effect, 
to  prevent  panic.  Thanks  to  the  "entente"  between  the  State  and 
a  small  number  of  banks  which  have  their  headquarters  or  (as  in  the 
case  of  the  Darmstadter  and  the  Dresdner)  their  center  of  gravity 
at  Berlin,  intervention  becomes  rapid  and  efficacious.' 

While  in  the  United  States  there  has  long  been  popular 
distrust  of  Wall  Street,  the  movement  toward  financial  con- 

'  Report  of  the  Committee  Appointed  to  Investigate  the  Concentration  ef 
Control  of  Money  and  Credit,  62d  Cong.,  3d  Sess.,  No.  1593,  pp.  132-33- 
*  Riesser,  Jacob,  Grossbanker,  p.  614. 


FINANCE  AND  ECONOMIC  ORGANIZATION  765 

centration  attracted  very  little  attention  until  the  panic  of 
1907.  At  that  time  there  developed  a  widespread,  though 
mistaken,*  belief  that  the  panic  was  engineered  by  a  group  of 
financiers  who  through  manipulation  of  the  financial  markets 
were  in  a  position  to  reap  a  golden  harvest  of  unprecedented 
proportions  at  the  expense  of  their  unfortunate  victims.  The 
belief  that  a  relatively  small  group  of  financiers  had  acquired 
a  commanding  control  over  the  major  industries  of  the  country 
was  strengthened  in  the  succeeding  years  by  the  increasing 
financial  concentration  that  immediately  followed,  by  the 
acknowledged  affiliation  of  the  larger  banking  institutions  of  the 
financial  centers  with  the  great  industrial,  railroad,  and  other 
consohdations  which  had  developed,  and  by  various  stories  which 
circulated  freely  in  financial  and  business  circles,  during  the 
latter  years  of  the  period  in  question,  to  the  effect  that  the 
underwriting  of  securities  as  well  as  the  extension  of  short- 
term  credit  were  denied  to  certain  corporations  for  no  other 
reason  than  that  they  chanced  to  be  competitors  of  corpora- 
tions in  which  the  directors  of  the  great  banking  institutions 
were  personally  interested.  None  of  these  charges,  it  should 
be  added,  was  ever  subsequently  shown  to  be  true.  The 
agitation  on  the  subject,  however,  finally  led  to  the  congressional 
"money  trust"  investigation  of  1912,  to  which  reference  has 
already  been  made. 

On  behalf  of  the  financial  interests  whose  integrity  was 
impugned  by  the  money  trust  investigation  of  the  Pujo  com- 
mittee, J.  P.  Morgan  &  Co.,  upon  invitation  of  the  committee, 
submitted  a  defense  of  financial  concentration.  While  this 
argument  is  not  altogether  conclusive  it  so  definitely  discloses 
the  fundamental  issues  involved  that  it  is  presented,  in  abbre- 
viated form,  herewith: 

Just  as  grain  and  cotton  and  manufactures  are  commodities 
subject  to  the  unchanging  laws  of  supply  and  demand,  so,  in  the  same 
way,  money  and  credits  are  commodities  subject  to  the  same  unvary- 
ing laws,  but  far  more  intensely;  for  while  bulky  merchandise  is 
not  always  immediately  transferable  upon  demand,   money  and 

'  See  the  analysis  on  pp.  511-29  above. 


766         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

credits  are  so  liquid  as  to  be  transferable  by  telegraph  all  over  the 
world.  Since  the  beginning  of  organized  industry  and  commerce, 
covering  more  than  two  centuries  in  England,  France  and  Germany 
and  one  hundred  years  in  America,  men  never  yet  have  succeeded 
in  overriding  economic  law;  and,  fiirther,  such  an  achievement  is 
impossible,  even  though  one  were  willing  to  attribute  sinister 
motives  to  the  leading  business  men  in  the  chief  cities  of  this 
country. 

In  the  preamble  to  the  House  Resolution  imder  which  your 
Committee  acts  we  find  this  statement:  "Whereas  it  has  been  further 
charged  and  is  generally  believed  [the  italics  are  our  own]  that  these 
same  groups  of  financiers  are  enabled  to  regulate  the  interest  rates 
for  money,  to  create,  avert,  and  compose  panics,  etc."  The  factors 
which  determine  interest  rates  are  not  local  in  their  source,  but  are 
world-wide,  being  determined  and — owing  to  the  freedom  of  inter- 
national exchange — ^being  regulated  by  the  average  demand  for 
credit  throughout  the  world's  money  markets.  If  any  man  or  group 
of  men  had  the  abiUty  and  resources — which  they  have  not — to 
withhold  credits  in  any  one  market,  like  New  York,  the  situation 
would  ordinarily  be  promptly  relieved  by  the  automatic  inflow  of 
credits  from  some  altogether  source. 

We  regret  that  a  beUef  so  incredible,  so  abhorrent,  and  so  harmful 
to  the  country  as  that  the  panic  of  1907  was  actually  due  to  the 
machinations  of  certain  powerful  men  should  for  a  moment  have 
foimd  lodgment  anjnvhere. 

No  one  will  deny  that  men  frequently  are  selfish,  ambitious,  and 
reckless,  but  in  order  to  sustain  the  theory  that  the  panic  of  1907 
was  "engineered"  one  must  attribute  some  motive  for  their  assumed 
achievements.  And  by  no  process  of  reasoning  can  such  motive 
be  imagined,  because  of  the  fact  that  men  possessing  even  a  fraction 
of  the  influence  and  resources  attributed  to  them  always  are  the 
ones  holding  the  largest  amounts  of  fixed  investments  which,  by 
disturbed  financial  conditions,  always  suffer  most  severely.  It  is 
impossible,  therefore,  to  imagine  a  motive  on  the  part  of  such  persons 
as  would  lead  to  a  campaign  of  self-destruction. 

The  resolution  under  which  your  Committee  acts  further  states 
that  a  comparatively  small  group  of  men  "have  wielded  a  power 
over  the  business,  commerce,  credits,  and  finances  of  the  countrj' 
that  is  despotic  and  perilous  and  is  daily  becoming  more  perilous 
to  the  public  welfare." 


FINANCE  AND  ECONOMIC  ORGANIZATION  767 

For  the  maintenance  of  such  an  impossible  economic  theory 
there  have  been  spread  before  your  Committee  elaborate  tables  of 
so-called  interlocking  directorates  from  which  exceedingly  mistaken 
inferences  have  been  publicly  drawn.  In  these  tables  it  is  shown 
that  180  bankers  and  bank  directors  serve  upon  the  boards  of  cor- 
porations having  resources  aggregating  twenty-five  billion  dollars, 
and  it  is  implied  that  this  vast  aggregate  of  the  country's  wealth 
is  at  the  disposal  of  these  180  men.  But  such  an  implication  rests 
solely  upon  the  untenable  theory  that  these  men,  living  in  different 
parts  of  the  country,  in  many  cases  personally  unacquainted  with 
each  other,  and  in  most  cases  associated  only  in  occasional  trans- 
actions, vote  always  for  the  same  policies  and  control  with  imited 
purpose  the  directorates  of  the  132  corporations  on  which  they  serve. 
The  testimony  failed  to  establish  any  concerted  policy  or  harmony 
of  action  binding  these  180  men  together,  and  as  a  matter  of  fact 
no  such  policy  exists.  The  absurdity  of  the  assumption  of  such 
control  becomes  more  apparent  when  one  considers  that  on  the 
average  these  directors  represent  only  one-quarter  of  the  member- 
ships of  their  boards.  It  is  preposterous  to  suppose  that  every 
"interlocking"  director  has  full  control  in  every  organization  with 
which  he  is  connected,  and  that  the  majority  of  directors  who  are  not 
"interlocking"  are  mere  figureheads,  subject  to  the  will  of  a  small 
minority  of  their  boards. 

Perhaps  the  greatest  harm  in  the  presentation  referred  to  lay 
in  the  further  unwarranted  inference,  to  which  has  been  given  wide 
publicity,  that  the  vast  sum  of  $25,000,000,000  was  in  cash  or  b'quid 
form,  subject  to  the  selfish  use  or  abuse  of  individuals.  Such  an 
idea  excites  the  public  mind  to  demand  the  correction  of  a  fancied 
situation  which  does  not  exist. 

The  steady  growth  in  the  size  of  banks  in  New  York  and  Chicago 
and  the  frequent  merger  of  two  or  more  banks  into  one  institution 
have  erroneously  been  designated  before  your  Committee  as  "con- 
centration." This  steady  growth  and  these  mergers,  however,  are 
a  development  due  simply  to  the  demand  for  larger  banking  facilities 
to  care  for  the  growth  of  the  country's  business.  As  our  cities  double 
and  treble  in  size  and  importance,  as  railroads  extend  and  industrial 
plants  expand,  not  only  is  it  natural,  but  it  is  necessary,  that  our 
banking  institutions  should  grow  in  order  to  care  for  the  increased 
demands  put  upon  them.  Perhaps  it  is  not  known  as  well  as  it 
should  be  that  in  New  York  City  the  largest  banks  are  far  inferior 


768         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

in  size  to  banks  in  the  commercial  cj^pitals  of  other  and  much  smaller 
countries.  The  largest  bank  in  New  York  City  today  has  resources 
amoimting  to  only  three-fifths  of  the  resources  of  the  largest  bank 
in  England,  to  only  one-fourth  of  the  resources  of  the  largest  bank 
in  France,  and  to  less  than  one-fifth  the  resources  of  the  largest 
bank  in  Germany.  As  the  Committee  is  aware,  in  New  York  City 
thore  are  only  three  banks  with  resources  in  excess  of  $200,000,000, 
while  there  are  ten  such  institutions  in  London,  five  in  Berlin,  and 
four  in  Paris. 

It  is  also  perhaps  not  sufficiently  recognized  that,  even  as  it  is, 
.\merican  banks  have  not  fully  kept  pace  with  the  development  of 
American  business.  Hundreds  of  the  financial  transactions  of  today 
are  so  large  that  no  single  bank  commands  sufficient  resources  to 
handle  them.  This  is  espedally  true  with  respect  to  the  great 
public  utilities  which  are  essential  for  the  development  and  welfare 
of  the  community.  Even  our  largest  banks  are  seldom  able  sepa- 
rately to  extend  the  credit  which  such  undertakings  require,  no  one 
national  bank  being  permitted  by  law  to  loan  in  excess  of  10  per 
cent  of  its  capital  and  surplus  to  any  one  individual  or  concern. 
When  it  is  remembered  that  literally  hundreds  of  corporations  in 
this  country  are  now  obh'ged  to  borrow  annually  sums  of  a  million 
dollars  and  upward  apiece,  it  is  obvious  that  the  size  of  our  banks 
must  grow  to  keep  pace  with  this  demand. 

We  lay  perhaps  especial  stress  upon  this  point,  because  of  what 
seemed  to  us  a  readiness  upon  the  part  of  your  Committee  to  adopt 
the  idea  that  in  such  co-operation  by  bankers  there  lies  the  germ 
of  something  sinister  and  dangerous,  and  that  "these  groups  of 
individuals"  can  "prevent  competition  with  the  enterprise  in  which 
they  are  interested,  to  the  detriment  of  interstate  commerce  and 
of  the  general  public."  So  far  as  our  observation  and  experience 
go,  we  can  make  the  positive  statement  that,  except  under  unfavor- 
able money-market  conditions,  we  have  never  heard  of  any  respon- 
sible and  deserving  individual,  firm,  or  corporation,  being  unable 
to  secure  ample  credit. 

Many  questions  were  asked  before  your  Committee  as  to  the 
wisdom  in  having  representatives  of  private  banking  houses  sit  upon 
the  boards  of  corporations  whose  securities  the  same  bankers  fre- 
quently offer  for  sale.  This  practice,  which  has  been  in  vogue  ever 
since  the  creation  of  limited  companies  has  arisen,  not  from  a  desire 
on  the  part  of  the  banker  to  manage  the  daily  affairs  of  the  corpora- 


FINANCE  AND  ECONOMIC  ORGANIZATION  769 

tion  or  to  purchase  its  securities  more  cheaply  than  he  otherwise 
could,  but  rather  because  of  his  moral  responsibility  as  sponsor  of 
the  corporation's  securities,  to  keep  an  eye  upon  its  policies  and  to 
protect  the  interests  of  investors  in  the  securities  of  that  corporation. 
For  a  private  banker  to  sit  upon  such  a  directorate  is  in  most  instances 
a  duty,  not  a  privilege.  Inquiry  will  readily  develop  the  fact  that 
the  members  of  the  leading  banking  houses  in  this  country — and 
it  was  the  leading  houses  only  against  which  animadversions  were 
directed — are  besought  continually  to  act  as  directors  in  various 
corporations,  whose  securities  they  may  handle,  and  that  in  general 
they  enter  only  those  boards  which  the  opinion  of  the  investigating 
public  requires  them  to  enter,  as  an  evidence  of  good  faith  that  they  are 
willing  to  have  their  names  publicly  associated  with  the  management. 

As  the  final  point  of  this  memorandum  we  venture  to  submit 
tl  consideration  that  in  a  strong  public  opinion,  such  as  exists  in 
this  country,  there  lies  the  greatest  safeguard  of  the  commimity. 
The  public,  that  is,  the  depositors,  are  the  ones  who  entrust  bankers 
with  such  influence  and  power  as  they  today  have  in  every  civilized 
land,  and  the  public  is  unlikely  to  entrust  that  power  to  weak  or 
evil  hands.  Your  coimsel  asked  more  than  one  witness  whether 
the  present  power  held  by  bankers  in  this  country  would  not  be 
a  menace  if  it  lay  in  evil  hands.  Such  an  inquiry  answers  itself. 
All  power — ^physical,  intellectual,  financial,  or  political — is  dangerous 
in  evil  hands.  If  Congress  were  to  fall  into  evil  hands  the  resiilts 
might  be  deplorable.  But  to  us  it  seems  as  httle  likely  that  the 
citizens  of  this  country  will  fill  Congress  with  rascals  as  it  is  that 
they  will  entrust  the  leadership  of  their  business  and  financial  aflfairs 
to  a  set  of  clever  rogues.  The  only  genuine  power  which  an  indi- 
vidual, or  a  group  of  individuals,  can  gain  is  that  arising  from  the 
confidence  reposed  in  him  or  them  by  the  community.  Every  town, 
large  or  small,  seems  to  choose  a  Umited  number  of  men  (merchants, 
manufacturers,  lawyers,  and  bankers)  to  represent  it  in  the  manage- 
ment of  its  chief  local  industries.  Those  men  are  entrusted  with 
such  heavy  responsibilities  because  of  the  confidence  which  their 
records  have  established,  and  only  so  long  as  their  records  are 
unblemished  do  they  retain  such  trusts. 

These  are  axioms  which  it  seems  almost  idle  to  repeat.  They  apply 
to  all  business,  but  more  emphatically,  we  believe  to  banking  than 
to  any  other  form  of  commerce.  To  banking  the  confidence  of  t  he 
community  is  the  breath  from  which  it  draws  its  hfe. 


i^O         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

While  the  congressional  investigating  committee  succeeded 
in  disclosing  this  extraordinary  degree  of  financial  consolidation 
and  aflSliation  that  have  been  indicated  above,  it  was,  however, 
unable  to  prove  the  existence  of  a  money  trust  or  any  extensive 
abuse  of  the  vast  financial  power  that  had  gravitated  by  the 
forces  of  industrial  and  financial  integration  into  the  control 
of  a  small  group  of  financiers.  The  committee  was  obliged 
to  conclude  its  report  with  this  statement:* 

If  by  a  "money  trust"  is  meant: 

"An  established  and  well-defined  identity  and  community  of 
interest  between  a  few  leaders  of  finance  which  has  been  created  and 
is  held  together  through  stock  holdings,  interlocking  directorates, 
and  other  forms  of  domination  over  banks,  trust  companies,  railroads, 
public-service  and  industrial  corporations,  and  which  has  resulted 
in  a  vast  and  growing  concentration  of  control  of  money  and  credit 
in  the  hands  of  a  comparatively  few  men,"  yoiu:  committee  has 
no  hesitation  in  asserting  as  the  result  of  its  investigation  that  this 
condition,  largely  developed  within  the  past  five  years,  exists  in 
this  country  today. 

It  may  be  that  this  recently  concentrated  money  power  so  far 
has  not  been  abused  otherwise  than  in  the  possible  exaction  of 
excessive  profits  through  absence  of  competition.  WhUst  no  evidence 
of  abuse  has  come  to  the  attention  of  the  committee  from  impartial 
soiuces,  neither  has  there  been  adequate  proof  or  opportunity  for 
proof  on  the  subject.    Here  again  th^p  data  have  not  been  available. 

Your  committee  is  convinced  that  however  well  founded  may  be 
the  assurances  of  good  intentions  by  those  holding  the  places  of 
power  which  have  been  thus  created,  the  situation  is  fraught  with 
too  great  p)eril  to  our  institutions  to  be  tolerated. 

Although  the  congressional  investigation  failed  to  prove 
the  existence  of  a  money  "  trust,"  it  clearly  indicated  that  the 
latest  phase  of  our  financial  evolution  has  placed  in  the  hands 
of  the  financial  interests  an  enormous  power  which,  if  wielded 
with  sinister  intent,  or  merely  with  unwisdom,  would  be  fraught 
with  tremendous  social  and  economic  consequences.     It  is  the 

'  From  the  Report  of  the  Committee  Apf>ointed  to  Investigate  the 
Concentration  of  Control  of  Money  and  Credit,  62A  Cong.,  3d  Sess., 
PP-  I30-33- 


FINANCE  AND  ECONOMIC  ORGANIZATION  771 

consensus  of  opinion  among  students  of  finance — and  the  belief 
is  shared  by  many  of  the  leading  financiers  themselves — that 
the  present  concentration  of  financial  resources  contains  ele- 
ments of  very  real  danger  and  that  the  movement  has  pro- 
ceeded quite  far  enough. 

Interlocking  financial  directorates  have  been  made  illegal. 
The  practical  outcome  of  the  money  trust  investigation  was 
the  incorporation  in  the  Clayton  Act  of  October  15,  19 14,  of 
certain  provisions  designed  to  break  up  the  system  of  inter- 
locking directorates.    This  act  provides, 

that  no  person  shall  at  the  same  time  be  a  director  or  other  officer  or 
employee  of  more  than  one  bank,  banking  association,  or  trust  com- 
pany organized  or  operating  under  the  laws  of  the  United  States, 
either  of  which  has  deposits,  capital,  surplus,  and  undivided  profits 
aggregating  more  than  $5,000,000;  and  no  private  banker  or  person 
who  is  a  director  in  any  bank  or  trust  company,  organized  or  operating 
under  the  laws  of  any  state,  having  deposits,  capital,  surplus,  and  undi- 
vided profits  aggregating  more  than  $5,000,000,  shall  be  eligible  to 
be  a  director  in  any  bank  or  banking  association  organized  or  operating 
under  the  laws  of  the  United  States. 

The  law  further  provides  that  no  bank,  banking  association,  or 
trust  company  operating  under  the  laws  of  the  United  States  which 
is  located  in  a  city  of  more  than  200,000  population  shall  have  as  a 
director,  officer,  or  employee  any  private  banker,  or  any  director^ 
officer,  or  employee  of  any  other  bank,  banking  association,  or  trust 
company  located  in  the  same  city. 

There  are  three  exceptions  to  the  prohibition  against  interlocking 
directorates,  besides  the  qualifications  respecting  the  size  of  institu- 
tions and  the  population  of  the  places  where  located.  These  are:  (i) 
the  prohibition  does  not  apply  to  mutual  savings  banks  which  have 
no  capital  stock;  (2)  the  director,  officer,  or  employee  may  be  an 
officer  where  the  entire  capital  stock  of  one  is  owned  by  the  stock- 
holder in  the  other;  and  (3)  the  prohibition  does  not  apply  to  a 
Class  A  director  in  a  Federal  Reserve  bank  who  serves  as  a  director, 
or  employee,  in  a  member  bank. 

In  accordance  with  the  requirements  of  the  Clayton  Ac( 
there  has  been  a  more  or  less  complete  readjustment  of  director- 
ates among  the  institutions  concerned.     No  evidence  has  ay 


772         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

yet  been  advanced,  however,  to  indicate  that  this  formal 
compliance  with  the  law  has  any  more  efiFectively  destroyed  the 
"communities  of  interest"  that  existed  than  was  the  case  follow- 
ing the  dissolution  proceedings  in  the  field  of  industrial  and 
railroad  consolidations. 

VI.    FINANCIAL  POWER  AND  THE  CONTROL  OF 
UNDEVELOPED  REGIONS 

One  further  phase  of  the  problem  of  financial  power  and 
control  must  be  briefly  mentioned.  Under  a  capitalistic 
economic  regime  the  backward  regions  of  the  earth  can  be 
brought  within  the  fold  of  commercial  civilization  and  their 
economic  wealth  made  available  for  world-uses  only  through 
the  use  of  very  large  financial  resources.  Accordingly,  financial 
penetration  and  exploitation  has  been  the  necessary  fore- 
runner and  handmaiden  of  modern  colonial  development. 
While  all  of  the  leading  commercial  nations  of  Europe  have 
long  utiUzed  their  financial  resources  to  this  end,  it  remained 
for  imperial  Germany  to  carry  the  process  to  its  final  degree 
of  perfection.  A  detailed  study  of  the  financial  methods  em- 
ployed in  this  connection  and  of  the  economic  and  social  sig- 
nificance of  this  union  of  finance  and  politics  would,  however, 
carry  the  present  discussion  so  far  afield  that  it  cannot  be 
undertaken  here. 

It  should  be  noted,  however,  that  the  animus  for  the 
extension  of  financial  assistance  to  undeveloped  countries  need 
not  be  entirely  imperialistic.  Such,  for  instance,  appears  to 
be  the  case  with  the  consortium  of  American,  British,  French, 
and  Japanese  groups  of  bankers  that  is  now  being  organized 
for  extending  to  China  credit  to  be  used  in  the  development  of 
public  works.  While  opinions  may  differ  as  to  the  motivating 
force  back  of  this  arrangement,  there  is  at  least  some  basis 
for  the  contention  that  it  is  more  in  the  nature  of  an  ordinary 
business  proposition  than  of  a  scheme  for  imperial  aggrandize- 
ment, for  the  reason  that  the  nations  involved  have,  themselves, 
sharply  conflicting  national  interests.    In  any  event  the  pre- 


FINANCE  AND  ECONOMIC  ORGANIZATION  773 

liminary  announcement  of  the  terms  of  the  arrangement  reveal 
in  a  most  striking  manner  the  tremendous  power  that  is  inherent 
in  the  control  of  modern  finance. 

It  is  reported  that  the  Chinese  government  has  pledged 
with  the  banking  consortium  as  security  for  a  loan,  the  surplus 
revenue  derived  from  the  salt  "gabelle,"  customs  duties,  and 
other  national  income,  and  has  agreed,  with  the  aid  of  foreign 
capital,  to  work  for  the  promotion  of  the  following  economic, 
political,  and  social  program:  the  development  of  mining, 
manufacturing,  and  agriculture;  the  colonization  of  the 
unsettled  portions  of  Chinese  territory;  the  moderization  of 
the  country,  including  the  introduction  of  universal  education 
and  the  development  of  the  legal  system  along  western  lines, 
especially  in  regard  to  the  procedure  of  arrest  and  trial  by 
jury  with  a  view  to  the  ultimate  abohtion  of  extra-territoriahty ; 
the  introduction  of  local  self-government;  the  stabilization  of 
the  foreign  poUcy  of  the  nation;  the  reunification  of  the  North 
and  the  South;  and  the  reduction  of  the  Army  and  Navy  to 
the  requirements  necessary  for  the  maintenance  of  the  domestic 
peace  and  order.  The  use  of  these  mihtary  forces  for  foreign 
aggression  is  forbidden.  It  is  thus  apparent  that  the  destiny 
of  China  largely  rests  in  the  hands  of  the  financiers  of  the 
world — ^mainly  of  the  Western  World. 

Such  is  the  financial  system  that  has  resulted  from  the 
great  changes  in  economic  organization  that  have  attended 
the  transformation  from  the  medieval  handicraft  and  manorial 
system  to  the  era  of  twentieth-century  capitahstic  enterprise. 
For  good  or  for  ill  the  economic  system  has  become  predomi- 
nantly pecuniary;  modern  life  is  largely  organized  about  the 
pecuniary  unit  of  calculation;  business  processes  are  every- 
where worked  out  through  financial  means;  and  even  the 
larger  aspects  of  economic  organization  are  in  no  small  measure 
regulated  through  the  intermediation  of  financial  institutions 
and  agencies.  There  is  Uttle  exaggeration  in  saying  that  the 
economic  society  of  our  times  is  financially  organized  and 
controlled. 


774         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

This  study  has  endeavored  neither  to  demonstrate  that  the 
modern  financial  system  is  the  embodiment  of  economic  per- 
fection or  that  it  is  inherently  vicious  in  its  economic  and  social 
consequences.  The  effort  has  rather  been  to  reveal  the  forces 
responsible  for  its  development,  to  disclose  the  various  economic 
services  rendered  by  the  numerous  individual  financial  insti- 
tutions and  agencies  that  make  up  the  financial  structure,  and 
to  indicate  the  functions  performed  by  this  larger  financial 
system  in  the  general  economic  organization.  The  definite 
purpose  has  been  to  describe  the  financial  system  as  it  is — to 
portray  its  weaknesses,  as  well  as  its  elements  of  strength 
in  performing  the  tasks  assigned.  Certain  specific  problems  of 
regulation  and  control,  and  certain  fundamental  issues  concern- 
ing the  relationship  of  .finance  to  the  larger  economic  organiza- 
tion have  been  raised,  but  not  resolved.  The  working  out  of 
such  reformation  or  reorganization  of  the  system  as  is  necessary 
to  render  it  more  fully  subservient  to  the  requirements  of 
economic  society  is  rather  the  task  of  the  present  and  of  the 
succeeding  generations.  If  this  volume  contributes  something 
to  that  understanding  of  the  problems  of  financial  organiza- 
tion without  which  inteUigent  reconstruction  is  impossible,  its 
purpose  will  have  been  amply  fulfilled. 

QUESTIONS  FOR  DISCUSSION 

1.  Draw  up  a  statement  in  outline  form,  indicating  all  of  the  ways 
in  which  the  pecuniary  system  renders  economic  services. 

2.  Draw  up  in  summary  form  a  statement  of  all  of  the  weaknesses 
which  you  find  in  the  financial  organization  of  society. 

3.  Draw  up  a  statement  showing  the  interrelations  of  finance  and 
the  general  economic  system. 

4.  "The  growth  of  large  scale  industry  necessitated  the  development 
of  national  supervision  of  the  banking  system."    Why  ? 

5.  Concretely,  how  great  is  the  control  of  the  individual  commercial 
banker  over  the  business  of  his  community,  where  there  are 
competing  banks  in  the  field  ? 

6.  Do  you  know  of  any  cases  where  commercial  bankers  have 
misused  the  power  which  they  possess  by  virtue  of  their  control 
over  loanable  funds  ? 


FINANCE  AND  ECONOMIC  ORGANIZATION  775 

7.  Draw  up  in  outline  form  a  statement  of  the  ideal  qualifications 
which  members  of  the  Federal  Reserve  Board  should  possess. 

8.  "The  world  has  become  an  economic  unit."  Do  you  think  this 
statement  holds  true  so  far  as  the  financial  aspects  of  things  are 
concerned  ? 

9.  "There  is  just  as  much  reason  why  we  should  have  a  system  of 
international  financial  control  as  a  system  of  national  financial 
control."    Why  or  why  not  ? 

10.  Cite  as  many  illustrations  as  possible -of  the  difficulties  arising 
from  the  control  of  finance  by  individual  nations,  rather  than  by 
an  international  organization. 

11.  Account  for  the  concentration  movement  in  finance  in  the  United 
States.  Do  you  see  any  means  by  which  it  could  have  been 
prevented  ? 

12.  Show  in  what  ways  the  growth  of  financial  concentration  was 
necessary  to  the  growth  of  corporate  consolidations  in  the  fields 
of  industry  and  commerce. 

13.  If  you  had  been  in  a  position  to  control  our  economic  destiny, 
would  you  have  prevented  the  industrial  and  financial  revolution 
that  occurred  between  1897  and  191 2.    Why  or  why  not? 

14.  Is  the  financial  concentration  that  now  exists  confined  to  the 
investment  banking  field?  Is  it  in  any  sense  specialized  con- 
centration ? 

15.  Do  you  think  it  possible  for  a  group  of  large  financial  interests 
to  charge  what  rates  they  please  for  money  ?  Can  they  charge 
more  to  some  people  than  to  others  ? 

16.  Are  not  the  interests  of  financiers  and  of  the  people  identical  in 
that  without  general  business  prosperity  the  operations  of  the 
financiers  would  be  impossible  ? 

17.  Do  you  agree  that  the  investment  bankers  could  have  no  possible 
motive  for  causing  a  panic  in  1907,  or  at  any  other  time  ? 

18.  In  view  of  your  previous  study  of  the  economic  cycle  and  the 
history  of  the  panic  of  1907,  does  it  seem  to  you  likely  that  that 
panic  was  "engineered"  by  the  interests? 

19.  Do  you  think  that  it  is  necessarily  "preposterous"  to  suppose 
that  an  interlocking  director  may  have  full  control  of  the  policy 
of  a  company  ?    substantial  control  ?    Why  ? 

20.  In  your  opinion  is  it  likely  that  credit  has  often  been  refused 
to  deserving  borrowers  merely  because  such  borrowers  were  com- 
petitors of  enterprises  in  which  the  investment  bankers  theni- 
gelves  were  interested  ?    What  is  to  prevent  such  a  practice  ? 


776         THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 

21.  "The  so-called  money  txust  is  in  a  position  to  prevent  the  pro- 
curing of  credit  only  in  the  case  of  very  large  issues  of  securities." 
Why? 

22.  "Supposing  the  general  control  of  the  country's  greater  banking 
institutions  to  be  in  the  hands  of  a  financial  group  which  also 
dominated  certain  railway  companies  and  certain  industrial 
corporations,  would  it,  or  would  it  not,  be  possible  for  an  impor- 
tant legitimate  enterprise,  competing  with  those  railways  or 
industrial  corporations,  to  be  organized  as  easily  as  before? 
Human  nature  being  what  it  is,  the  answer  must  be  in  the  nega- 
tive."   Do  you  agree  ? 

23.  Have  you  known  of  cases  in  small  towns  where  the  banker  has 
refused  loans  to  those  who  were  competitors  of  his  in  non-banking 
lines? 

24.  Are  interlocking  directorates  necessarily  developed  for  sinister 
purposes  ? 

25.  On  the  whole,  do  you  beUeve  that  there  is  an  effective  "Money 
Trust"  ? 

26.  Do  you  feel,  with  J.  P.  Morgan  &  Company,  that  the  public  can 
safely  rely  upon  our  financial  representatives  to  safeguard  our 
interests  through  p>eril  of  deposition  as  soon  as  they  do  not 
warrant  oiu:  confidence?  Concretely,  how  is  the  process  of 
deposing  those  whom  we  no  longer  trust  brought  about  ? 

27.  "Although  the  present  directors  of  huge  financial  resources  may 
owe  their  position  to  a  process  of  competitive  selection  by  means 
of  which  the  especially  faithful  and  capable  administrators  have 
been  brought  to  the  top,  it  does  not  necessarily  follow  that  the 
descendants,  and  inheritors  of  the  wealth,  of  these  magnates  will 
have  the  same  ability  or  integrity."    Discuss  this  statement. 

28.  If  you  were  in  a  position  of  power,  what  would  you  do  to  minimize 
the  dangers  of  financial  concentration  ? 

29.  "China  should  be  allowed  to  work  out  her  own  economic  salvation 
without  financial  assistance  from  the  great  commercial  countries." 
What  do  you  think  of  this  statement  ? 

30.  "  Private  financiers  should  not  be  allowed  to  control  the  develop- 
ment of  backward  nations.  Such  aid  as  is  given  should  conxe 
from  governments  instead  of  from  private  interests."  Discuss 
this  suggestion. 

31."  The  greatest  safeguard  in  connection  with  the  economic  develop- 
ment of  backward  regions  lies  in  having  the  necessary  financial 


FINANCE  AND  ECONOMIC  ORGANIZATION  777 

assistance  rendered,  not  by  the  bankers  or  by  the  government 
of  a  single  country,  but  by  groups  of  bankers  in  different  countries, 
affliated  with  their  respective  governments."    Discuss. 

REFERENCES  FOR  FURTHER  READING 

Angell,  Norman:  The  Great  Illusion. 

Brandeis,  Louis  D.:  Other  People's  Money. 

Hauser,  Henri:  Germany's  Commercial  Grip  on  the  World. 

Kejoies,  J.  M.:  The  Economic  Consequences  of  the  Peace,  chaps,  ii 
and  vi. 

Moulton,  Harold  G.:  Principles  of  Money  and  Banking,  pp.  471-95. 

Phillips,  Chester  A.:  Readings  in  Money  and  Banking,  chap. 
xxviii. 

Report  of  the  Committee  Appointed  to  Investigate  the  Concentration 
of  Control  of  Money  and  Credit,  62d  Cong.,  3d  Sess. 


INDEX 


INDEX 


Accommodation  draft,  164 

Accounts  payable,  162,  168 

Accounts  receivable,  162,  168 

Affiliated  banks,  729 

Agricultural  credit,  chap,  on,  649-96; 
chart  of  institutions  involved  in, 
650;   legislation  of  states,  682-83 

Aldrich  Bill,  569-70,  572 

Aldrich-Vreeland  Act,  568 

Aldrich-Vreeland  emergency  cur- 
rency, 568-69 

American  Foreign  Securities  Co., 
266 

Amortization  loans,  678-80 

Arbitrage,  114 

Assay  commission,  71 

Assay  offices,  73 

Assigning  accounts,  438-39 

Automobile  bank  (see  Discount 
companies) 

Balance  of  trade,  significance  of, 
57-59,  since  the  war,  262-63,  4^4 

"Baltimore  plan"  of  currency  re- 
form, 567 

Bank   acceptance,    illustration   of,_ 
166;   372,  413;  basis  of  discoimt 
market,  601-21 

Bank  checks,  164;  in  a  sense  not 
credit  instruments,  164;  illustra- 
tion of,  167 

Bank  draft,  163;  not  true  credit 
instrument,  164;  illustration  of 
foreign,  167 

Bankers'  deposits,  473-74;  and 
financial  panics,  527-29 

Bank  examinations  and  reports, 
557-59 

Bank  failures,  causes  of,  551;  of 
various  classes  of  banks,  728-29 

Bank  loans  {see  Commercial  bank 
loans) 


Bank  notes,  164;  regulation  of, 
562-64  (see  also  National  Bank 
notes.  Federal  Reserve  Bank 
notes,  and  Federal  Reserve  notes.) 

Baring  Brothers,  214 

Barter,  inconvenience  of,  41;  inter- 
national post-war,  275 

Bill  of  exchange,  finance,  112,  164; 
trade  (or  commercial)  113,  164; 
definition  of,  162;  foreign  versus 
domestic  or  inland,  162;  illustra- 
tion of  banker's,  167;  sterling,  410 

Bill  of  lading,  nature  of,  394-95 ;  as 
security  for  loans,  395;  kinds  of, 
396;  illustration  of,  398;  in  foreign 
trade,  413 

Bill  of  Lading  Act,  396 

Bimetallism,  and  Gresham's  Law, 
73-79;  reasons  for  adoption  of, 
73;  weakness  of,  74;  history  of, 
in  U.S.,  74-75;  and  compensatory 
action,  77-79;  international,  77, 
78-79;  possible  restoration  of, 
80-81 

Bland-Allison  Act,  77,  100 

Blue  Sky  legislation,  197-210;  of 
Kansas,  191-92;  of  Illinois,  198- 
205;  bill  in  Congress,  206 

juonas,  advantages  6f,  ^4*}  types  01, 
i55~S7j  illustration  of,  158-59; 
determination  of  value  of,  chart, 
222 


Buuk  cfWlll  (book  accounts),  162, 
169 

Borrower's  statement,  illustration 
of,  381 

Brokers  (see  chart  136);  street,  242; 
stock  exchange,  285-92;  com- 
missions of,  289;  branch  oflBices, 
290;   regulation  of,  292. 

Bubble  Act  of  17 19,  142 

Bucket  shops,  292 

Building  and  loan  associations, 
714-19 


781 


782 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


Business  booms,  {see  Business  cycles) 

Business  cycles,  chap,  on,  494-546; 
in  U.S.,  505;  causes  of,  511-19; 
and  commercial  banking,  519-41; 
and  the  economic  system, 
749;  and  individual  banker's  con- 
trol, 752-3 

Business  depression  (see  Business 
cycles) 

Business  failures  and  seasonal  mone- 
tary stringency,  502;  in  time  of 
depression,  509-10 

Call  loans,  definition  of,  376;  and 
stock  exchange  speculation,  391- 
94;  in  time  of  crisis,  531;  of 
Canadian  borrowers,  645 

Capital  formation,  under  a  capital- 
istic system,  49-50 

Capital  Issues  Committee,  206 

Capital  raising,  the  corporation  and, 
chap,  on,  139-50;  through  reinvest- 
ment, 135;  by  direct  subscription, 
135;  through  promotion,  186-97 

Cash  discount,  26 

Cashier's  check,  164;  illustration  of, 
167 

Cattle  loan  company,  chart,  650; 
functions  of,  659-65 

Cattle  paper,  663 

Central  banks,  opposition  to,  569; 
European  and  credit  control,  753 
(see  also  First  and  Second  Banks 
of  the  United  States.) 

Central  reserve  cities,  meaning  of 
term,  371 

Certificates  of  deposit,  374 

Certified  check,  164 

Chattel  mortgage,  illiistration  of, 
445 

Checks  {see  Bank  checks) 

Clayton  Act,  773 

Clearing-house  associations,  457-70 

Clearing-house  bank  examinations, 

468-70 
Clearing-house  certificates,  460-61 
Clearing-house  checks,  538 
Clearing-house     loan     certificates, 

533-38 


Clearings  under  Federal  Reserve 
System,  608-13 

Coinage,  necessity  of,  65;  a  govern- 
ment function,  66;  effects  of  bad 
system  of,  67-69;  regulations  in 
United  States,  69-73;  abrasion  of, 
72;  coimterf citing  of,  72 

Collateral  loans,  386-90;  to  member 
banks,  592-93 

Collateral  trust  bond,  157,  308 

Collection  charges,  467;  diversity 
of,  609;  reduction  of,  under 
Federal  Reserve  System,  612-13 

Collections,  470-72;  under  Federal 
Reserve  System,  608-13 

Commercial  Acceptance  Trust  {see 
Discoimt  companies) 

Commercial  agencies,  379 

Commercial  banker,  dominant  posi- 
tion of ,  751-53 

Commercial  bank  investments,  374; 
kinds  of,  401;  volume  of,  401-2, 
488 

Commercial  banking  system,  chap, 
on,  457-93,  and  business  cycles, 
chap,  on,  494-546  {see  also 
Commercial  banks) 

Commercial  bank  loans,  analysis  of, 
374;  importance  of,  375;  type  of, 
375-76;  classification  of,  in 
national  banks,  377;  capital  pur- 
poses, 383-84,  487,  724;  secured 
by  mortgages,  385;  secured  by 
promissory  notes,  385;  secured 
by  stocks  and  bonds,  386;  secured 
by  bills  of  lading,  394;  secured  by 
warehouse  receipts,  397;  and 
deposits  compared,  479;  foi 
fixed  in  time  of  crisis  (table) 
530;  regulation  of,  553-56 

Commercial  banks,  chap,  on  practi- 
cal operations  of,  357-409;  posi- 
tion in  financial  structure  (see 
charts  134,  136,  650),  375,  488, 
529;  classification  of,  358;  growth 
and  importance  of,  charts,  359, 
360;  incidental  services  of,  36 1-63: 
investments  of  {see  Commercial 
bank  investments);  and  foreign 
trade,  chap,  on,  410-426;  relation 
to  commercial  paper  houses,  429; 
relation   to  discount  companies, 


INDEX 


783 


441;  and  economic  organization, 
486-88;  and  business  cycles, 
519-41;  and  agricultural  credit, 
656-69;  engaging  in  trust  com- 
pany operations,  729-30 

Commercial  credit,  124 

Commercial  credit  companies  {see 
Discoimt  companies) 

Commercial  credit  instruments,  162- 
69  {see  also  credit  instruments) 

Commercial  letters  of  credit  {see 
Letters  of  credit) 

Commercial  loans,  nature  of,  376 
{see  also  Single-name  and  Two- 
name  paper) 

Conunercial  paper,  street  use  of 
term,  434;  as  secondary  reserve, 
475;  not  liquid  in  time  of  crisis, 
532-33 

Commercial  paper  houses,  chart, 
136,  427-37;  economic  signifi- 
cance of,  435 

Common  denominator  of  value  {see 
pecxmiary  irnit) 

Common  stock,  140,  153-54 

"Community  of  interest,"  729,  772 

"Compensated"  dollar  {see  "Stabil- 
ized" dollar) 

Comptroller  of  the  Currency,  394; 
duties  of,  558 

Comstock  Lode,  80 

Concentration  of  money  and  credit 
{see  Financial  concentration) 

Conditional  sale  agreement,  illustra- 
tion of,  447 

Consolidated  stock  exchange,  281, 
284 

Consortium  of  international  bankers, 
772-73 

Consumptive  credit,  definition  of, 
125 

Consumptive  credit  institutions, 
chap,  on,  697-722 

Contingent  liabilities,  380 

Control  of  discount  rates,  under 
Federal  Reserve  System,  593, 
597-98;  after  the  war,  634-39 

Co-operative  credit  associations, 
agricultural,  652;    708-14 


Corporate  reorganizations,  312 

Corporation,  relation  to  financial 
structure,  (chart  136),  750;  "close," 
13s;  as  capital  raising  device, 
chap,  on, 139-50 

Correspondent  banks,  470-75 

Cotton  "factor,"  655 

Coimtry  banks,  meaning  of  term, 
371 

Credit,  nature  and  fimctions  of. 
121-31;  kinds  of,  122-23;  invest- 
ment, 124;  commercial,  124; 
consumptive,  125;  basis  of,  125- 
27;  significance  of,  127-29;  book, 
162 

Credit  analysis,  378-83 

Credit  currency  {see  Deposit  cur- 
rency) 

Credit  department,  379 

Credit  instruments,  122;  chap.  on. 
151-84;  investment,  1 51-61;  com 
mercial,  162-69;  as  media  of 
exchange,  170 

Creditor  nation,  1 18,  260,  424 

Credit  unions  {see  Co-operative 
credit  associatioils) 

Crime  of  1873,  77,  79 

Crises  {see  Business  cycles) 

Crop  liens,  amount  of,  653;  nature 
of,  654 

Curb  market,  280;  volume  of 
transactions  on,  281;  importance 
of,  284-85 

Currency  act  of  1900,  85;  banking 
provisions  of,  567 

Custodian  of  Securities,  316-21 

Cyanide  process,  80 

Debenture  bond,  157 
Decentralized  banking,  522-23 
Deflation,  process  of,  639-43 
Demand  loans,  definition  of,  376 
Department-store  finance  {see  Finan- 
cial integration) 
Depositary  banks,  for  government 

funds,  373;  614-15 
Deposit  currency,  origin  of,  366-70 
475-80;  increasing  importance  of 
372;    amount  of,   483-85;    and 


784        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


prices,  485;  elasticity  of  (chart), 
499;  reasons  for  elasticity,  501-2; 
elasticity  of,  under  Federal  Re- 
serve System,  594-96 

Depressions  {see  Business  cycles) 

Discount  companies,  chart,  136; 
437~S4j  economic  significance 
of,  453 

Discount  Corporation  of  New  York, 
608 

Discoimt  market,  nature  and  fimc- 
tions  of,  600-608 

Discount  rates,  control  of,  593, 
597-98,  634-39  {see  also  Interest 
rates) 

Discounting  receivables  {see  Assign- 
ing accoimts) 

Dollar  drafts,  import,  414;  export, 
418,  420 

Domestic  exchange,  115-16,  472 

Double  liability  of  bank  share- 
holders, 552-53 

Draft  {see  Bills  of  exchange,  trade 
acceptance,  bank  draft,  accom- 
modation draft) 

Edge  Act,  passage  of,  263;  and 
American  foreign  investments, 
264-67;  and  direct  financing  of 
exports,  422-23 

Elastic  oirrency  {see  also  Inelastic 
cmrency),  under  Federal  Reserve 
System,  577-96 

Equalization  of  reserves,  S33~37 

Equipment  trust  obligations,  156, 
308 

Escrow,  meaning  of,  304 

Essential  credits,  641 

European  debt  to  U.S.,  272;  can- 
cellation of,  275-76 

European  reconstruction,  and 
American  loans,  267 

Farm  mortgage  broker  (chart,  650), 

667 
Farm  mortgage  companies  (chart, 

650),  668,  672  {see  also  Mortgage 

companies) 
Farm  indebtedness,  working  capital, 

653;  fixed  capital,  665-66 


"Farmers'  bank,"  657 
Federal  Advisory  Council,  576 
Federal  Farm  Loan  Act,  p>assage  of, 

674 

Federal  Farm  Loan  Board,  nature 
and  general  powers  of,  674 

Federal  Farm  Loan  districts,  map  of, 
676 

Federal  Farm  Loan  Registrar,  677, 
682 

Federal  Farm  Loan  System,  organi- 
zation of,  672-82;  loans  of,  685; 
results  of,  686-87;  criticisms  of, 
688-90 

Federal  Land  banks  (chart  650), 
675;  financial  statement  of, 
684-85 

Federal  Reserve  Act,  evolution  of, 

570-72 

Federal  Reserve  Agent,  575, 580,  588 

Federal  Reserve  banks,  collateral 
loans  of,  373;  financial  state- 
ments of,  616-18;  interborroAying 
operations  of,  644 

Federal  Reserve  bank  notes,  amount 
of,  103;  regulation  of,  578-79; 
legal  tender  of,  589 

Federal  Reserve  Board,  and  ad- 
nainistration  of  Edge  Act,  264-65, 
423;  general  powers  and  duties 
of,  576-77;  extraordinary  power 
of,  over  economic  system,  752-54 

Federal  Reserve  districts,  map  of, 
573;  size  of,  574 

Federal  Reserve  notes,  amount  of, 
103;  regulation  of,  580-89;  legal 
tender  of,  589 

Federal  Reserve  System,  chaps,  on, 
566-648;  and  export  financing, 
264-65;  410-21;  and  foreign 
branch  banks,  421-22;  position 
in  financial  structure,  charts, 
134,  136,  650;  and  control  of 
business  cycle,  593-608;  and  war 
finance,  624-31;  and  state 
banks,  735-39;  and  savings 
banks,  742 

Jiat  currency,  91 

Finance  companies  (see  Discount 
companies) 


INDEX 


785 


Financial  concentration,  756-57; 
in  New  York,  758;  in  Germany, 
758-61;  Congressional  investi- 
gation of,  761-64;  defense  of, 
by  Morgan  and  Company,  765- 
69;  and  control  of  undeveloped 
regions,  772-73 

Financial  crises  (see  Business  cycles) 

Financial  integration,  137,  323; 
chap,  on,  723-42;  and  concentra- 
tion, 762 

Financial  organization,  international 
aspects  of,  273-76;  754-56 

Financial  panics  {see  Business  cycle) 

Financial  reorganizations,  312 

Financial  statement,  illustration  of, 
381 

Financial  structure,  3;  132-38; 
charts  of,  134,  136,  218,  650;  749 

Financial  system,  and  the  general 
economic  organization,  chap,  on, 
743-777;  interdependence  of, 
748-49  {see  also  Pecuniary  system) 

First  Bank  of  the  United  States,  549 

First  Federal  Foreign  Banking 
Association,  423 

Fiscal  agency,  313-15 

Fixed  capital,  2,  8,  132;  charts  on, 
134,  136,  650 

Foreign  Bond  and  Share  Corpora- 
tion, 267 

Foreign  branch  banks,  421-22 

Foreign  exchange,  chap,  on,  107-120; 
during  the  war,  116-17;  pegging 
of,  117;  depreciation  of,  117-18, 
and  export  trade,  262-63;  ^^^ 
international  indebtedness,  269-72 

Foreign  Finance  Corporation,  268 

Foreign  financing,  chaps,  on,  256- 
78,  410-26  (see  also  Investment 
trusts  and  Foreign  trade) 

foreign  investments,  and  free  silver 
agitation,  28;  of  U.S.,  118;  in 
the  U.S.,  214;  of  Great  Britain, 
256;   future  of  American,  269-73 

Foreign  Investment  Trusts  {see 
Investment  trusts) 

Foreign  trade,  since  the  war, 
262-63;  financing  of  {see  Foreign 
financing) 


Fractional  silver  coins,  redemption 
of,  84;  legal  tender  of,  86;  amount 
of,  103 

"Free  banking"  law  of  New  York, 
552 

Free  silver  agitation,  and  interna- 
tional finance,  27-28;  and  domes- 
tic finance,  28;  and  farmers,  38; 
and  pensions,  39;  and  creditors,  39 

German  banking,  concentration  of, 
758-61 

German  financial  concentration, 
758-61,  764 

German  indemnity,  and  the  foreign 
exchanges,  274;  cancellation  of, 
275-76;   difl&culty  in  pa3ang,  755 

Gold,  why  chosen  as  standard,  19, 
79-83;  durability  of,  19;  relative 
stability  of,  20;  production  of, 
82;  commercial  ratio  of,  to  silver, 
83;  international  flow  of,  115; 
domestic  flow  of,  116;  holdings  of 
leading  nations  (chart),  271 

Gold  certificates,  100;  redemption 
of,  102;  amount  of,  103;  legal 
tender  of,  104;  exchanged  for 
Federal  Reserve  notes,  577 

Gold  clearance  {see  Gold  settlement 

fund) 
Gold  coin,  weight  of,  4;  legal  tender 

of,  85;  amount  of,  103 

Gold  dollar,  definition  of,  21 

Gold  exchange  standard,  77 

Gold  points,  112 

Gold  settlement  fund,  611 

Gold  standard,  history  of,  75-77; 
law  of  1900,  77 

Government  regulation  of  banking, 
chap,  on,  547-65 

Great  Illusion,  the,  755 

Greenback  currency,  and  trading 
methods,  25-27;  and  debtor  class, 
32;  purpose  and  nature  of,  loi; 
amount  of,  loi,  103;  redemption 
of,  102;  legal  tender  provisions 
of,  104 

Gresham's  Law,  and  defective  coin- 
age, 66;   and  bimetallism,  73-79 


786        THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


High-grade    securities,    chap,    on, 

2II-5S 
Hoarding,  and  financial  panics,  527; 

and  Federal  Reserve  System,  644 

Indemnity  {see  German  indemnity)  , 

Independent  treasury,  503  {see  also 
Depositary  banks) 

Index  numbers,  purpose  of,  22; 
method  of  computing,  22;  nature 
of,  23 

Inelastic  currency  {see  also  Elastic 
currency),  under  national  banking 
system,  497-502;  and  financial 
crises,  525-26 

faflation,  process  of,  628-30;  in 
Europe,  630-31 

Insurance  companies  (charts)  134, 
136,  650;  and  bond  distribution, 
237;  as  savings  institutions, 
344-48 

Integration  {see  Financial  integra- 
tion) 

Inter-bank  borrowing,  474-75 

Interest  rates,  in  New  York  City 
(chart),  393;  on  deposits,  465; 
on  loans,  466  {see  also  Discount 
rates) 

Interlocking  directorates,  system  of, 
761-64;  declared  illegal,  771 

International  barter,  275 

International  finance,  control  of, 
754-56  {see  also  Foreign  exchange) 

International  indebtedness,  and  for- 
eign exchange,  269-72;  cancel- 
lation of,  275-76;  difficulty  in 
paying,  756 

Investment  banking,  interrelations 
with  financial  system  (chart)  136; 
history  of,  212-17;  functional 
chart  of,  218;  function  of  investi- 
gation and  analysis,  218-28; 
function  of  underwriting  {see 
Underwriting);  function  of  dis- 
tribution, 234-40;  sundry  services 
of,  240-43;  profits  of,  243-45;  reg- 
ulation of,  245-47;  and  economic 
organization,  247-51;  concentra- 
tion and  integration  of,  761-6* 

Investment  credit,  124 

Investment  loans,  nature  of,  376-90 


Investment  trusts,  chap,  on,  256-78; 
of  Great  Britain,  257-60;  Ameri- 
can authorized,  263--69 

Joint-stock  land  banks  chart,  650, 
681-82;    growth  of,  685-86 

Klondike  gold  mines,  80 

Lease  agreement,  illustration  of, 
452 

Legal  tender,  purpose  of,  85;  of 
metallic  money,  85-86,  of  govern- 
ment paper  money,  103-5;  o^ 
national  bank  notes,  371;  of 
Federal  Reserve  Bank  and  Federal 
Reserve  notes,  589 

Letter  of  credit  agreement,  illustra- 
tion of,  416 

Letters  of  credit,  372,  411-14; 
illustration  of,  417 

Limited  liability,  advantages  of, 
141-43 

"Limping  standard,"  76 

Liquidation  of  loans,  automatic 
theory,  532;  annual,  532 

"Living  trusts,"  305 

Loan  sharks,  703-8 

London  stock  exchange,  214,  256 

Low  grade  securities  {see  Speculative 
securities);  and  stock  exchange 
speculation,  296 

"Margin"  trading,  286-87,  392 

McLean  Act,  264 

Medium  of  exchange,  function  of, 
41-42;  and  capitalistic  produc- 
tion, 43 

Mercantilism,  57-59,  744 

Metallic  currency,  regulation  of, 
65-90;  subsidiary  forms  of,  84-85; 
legal  tender  of,  85-86 

Minor  coins,  redemption  of,  84; 
legal  tender  of,  86 

Mint,  charges  at,  69-70;  tolerance 
of,  71;  of  United  States,  73 

Monetary  unit  {see  Pecuniary  unit) 

Money,  as  store  of  value,  42;  and 
business  organization,  43-44;  use 
in  production,  43-45;    and  war 


INDEX. 


787 


finance,  45-48;  and  peace  finance, 
48-50;  and  distribution  of  pro- 
ductive energy,  49-50;  and  capital 
formation,  49-50;  confusion  of 
with  wealth,  56-60;  quantity 
required,  60-62;  regulation  of 
metallic,  chap,  on,  65-90;  regula- 
tion of  paper,  chap,  on,  91-106; 
stock  of,  and  kinds,  in  U.S.,  103 

Money  rates  {see  Interest  rates) 

Money  trust  {see  Financial  concen- 
tration) 

Morgan  &  Co.,  217,  268,  761; 
defense  of  financial  concentration, 
765-69 

"Morning"  loans,  394 

Morris  Plan  Bank,  708 

Mortgage  companies  (chart),  134 
{see  also  Farm  mortgage  com- 
panies) 

Mortgage  security,  152;  significance 
of,  156;  trustee  for,  307 

National  Bank  Act,  548 

National  bank  notes  {see  also  Bank 
notes);  amount  of,  103;  regula- 
tion, 370;  legal  tender  of,  371; 
declining  importance  of,  371-72; 
inelasticity  of  (chart),  499; 
reasons  for,  500-501;  under 
Federal  Reserve  System,  577-78 

National  banks,  358;  loans  of,  377; 

investments  of,  401. 
National  Citizens'  League,  570 
National  Farm  Loan  associations, 

chart,  650;  675 
Negotiability     vs.     salability     and 
transferability,      171;      principle 
of,  172;   essentials  of,  175-78;  of 
bonds,  180;  of  stock,    180;   legal 
procedure  with,  175-77;  of  checks, 
bank  notes,  and  bank  drafts,  1 79 
Negotiable  Instruments  Law,  174 
New  York  Stock  Exchange,  280,  281 
Note    brokerage    {see    Commercial 
paper  houses) 

Open  accounts  {see  Accounts  receiv- 
able) 

Open  market  operations  {see  also 
Discount  market),  598-600 


Overcapitalization,  155 
Overcertification,  394 
Overdrafts,  332 

Panic  of  1907,  and  savings  banks, 

336 
Paper  currency ,  in  France,  24;  regu- 
lation of  government,  91-106; 
representative,  91;  convertible 
fiduciary,  91;  inconvertible  or 
fiat,  91;  irredeemable,  92;  con- 
federate, 93-96;  revolutionary, 
97;  value  of,  98;  depreciation  of 
European,  262,  270,  271 

Par  collections,  610-13 

Par  of  exchange,  109,  115 

Pawnbroking,  699-703 

Pecimiary  sj^tem,  and  economic 
and  social  standards,  chap,  on, 
53-64;  advantages  of,  744;  dis- 
advantages of,  745-48 

Pecuniary  imit,  definition  and  origin 
of,  4-6;  and  business  administra- 
tion, 6-1 1 ;  and  apportionment 
of  family  expenditures,  11-13; 
and  economic  organization,  13-15 

Pittman  Act,  loi 

Preferred  stock,  140, 153;  "modem" 
153-54;  illustration  of,  160-61 

Price  changes,  charts  of,  31,  626; 
causes  of,  23;  economic  con- 
sequences of,  23-30;  and  social 
maladjustments,  30-37;  and  Ger- 
man trade,  29-30;  in  United 
States,  1840  to  1920,  31;  after 
Civil  War,  33;  and  debtor  class, 
33-34;  ^nd  creditor  class,  34; 
after  1896,  34;  and  real  salaries 
and  wages,  35-36,  37,  and  fixed 
incomes,  35,  37;  and  savings, 
36-37 

Price  level,  definition  of,  22;  reasons 
for  decline  of,  in  1920,  639-43; 
control  of,  by  stabilized  dollar, 
748,  by  credit  restrictions,  753-54 
{see  also  Price  changes) 

Prices,  relation  of  money  to,   21; 

relation  of  deposit  currency  to, 

485 
private  banks,  358 


788 


THE  FINANCIAL  ORGANIZATION  OF  SOCIETY 


Promissory  note,  definition  of,  162; 
illustration  of,  163;  similarity  to 
trade  draft.  168-69 

Promotion,  methods  of,  186-97 

Prosperity,  periods  of  (see  Business 
cycles) 

Real  estate  loans,  of  national  banks, 
385;  of  state  banks,  385;  con- 
troversy over,  555-56;  without 
mortgage  security,  658 

Redemption  fund,  for  national 
bank  notes,  374 

Rediscounting,  before  Federal  Re- 
serve Act,  474-75;  under  Federal 
Reserve  System,  591-92 

"Refinancing,"  definition  of,  41^20 

Registrar  of  securities,  311-ia 

Reorganization,  corporate,  312 

Reserve  cities,  meaning  of,  371 

Reserves,  of  savings  banks,  341-42; 
of  commercial  banks,  475;  net 
in  banking  system  (chart),  479, 
482-83;  till  money,  480-81;  ulti- 
mate or  liquidation,  481 ;  redepos- 
iting  of,  482;  ratio  of,  to  deposits 
in  New  York  (chart),  498;  re- 
quirements under  National  Bank 
Act,  482;  imder  Federal  Reserve 
Act,  590-91;  and  deposits,  1897- 
19071  (table),  521;  and  financial 
panics,  526;  redepositing  of,  and 
financial  panics,  527-29;  equaliza- 
tion of,  533-37;  regulation  of, 
556-57;  requirements  for  Federal 
Reserve  notes,  588;  of  reserve 
banks  not  irreducible  minima,  597 

Rural  credit  (see  Agricultural  credit) 

Safety  deposit  vaults,  316 

Savings  banks,  and  bond  distribu- 
tion, 238;  chap,  on,  327-56; 
stock,  327-32;  mutual,  332-34; 
"guaranty"  333;  departments  in 
commercial  banks,  334-35;  pos- 
tal, 335-39;  management  of, 
339-43;.  aiid  agricultural  credit, 
651;  with  commercial  accounts, 
731;  seeking  trust  powers,  732; 
and  Federal  Reserve  System,  739 


Scandinavian  monetary  union,  76 
Seasonal   variations  in  demand  for 

currency,  495-502 
Secondary  reserves  in  time  of  panic, 

531-33 
Second  Bank  of  the  United  States, 

549-50 
Serial  notes  (see  Short-term  notes) 
Sherman  Silver  Purchase  Act,  77; 

repeal  of,  10 1 
Short-term  note,  157 
Silver  certificates,  100;  and  treasury 

notes,   loi;    redemption  of,  102; 

amount  of,  103;  legal  tender  of, 

104 

Silver  dollar,  now  a  subsidiary  coin, 
84;  coinage  of,  85;  method  of 
maintaining  parity,  85;  legal 
tender  of,  86;  amount  of,  103 

Silver,  price  fluctuations  of,  80-83; 
production  of,  82;  commercial 
ratio  to  gold,  83;  regulation  of 
subsidiary,  84;  fractional  coins, 
84 

Single  name  paper,  377-84;  used 
in  stock  exchange  speculation, 
393-94 

South  African  gold  fields,  80 

Speculation,  in  1688,  145;  in  1719, 
142;  in  1919,  191-92;  on 
"margin,"  286-87,  392;  control 
of,  636  (see  also  Stock  Exchange) 

Specxilative  securities,  185-210,  291 

Stabilized  dollar,  746 

Standard    for    deferred    payments, 

importance  of,  18;  why  gold  was 

chosen  as,  19 
Standard  of  value   (see  Pecuniary 

unit) 
State  banks,  358;    investments  of, 

402;    regulation  of,  558-62;   and 

Federal  Reserve  System,  735-39 

Stock,  advantages  of,  140;  preferred, 
140,  141;  common,  141;  preferred 
cumulative,  153;  preferred  partici- 
pating, 153;  modern  preferred 
almost  equal  to  bonds,  153;  with- 
out par  value,  154 

Stock  exchange  (chart,  136),  183;  and 
capital  raising,  chap,  on,  279-300: 


INDEX 


789 


of  London  {see  London  stock 
exchange) ;  of  New  York  (see  New 
York  stock  exchange);  consoli- 
dated {see  ConsoUdated  stock  ex- 
change) ;  committee  on  stock  lists, 
283;  brokers  {see  Brokers);  eco- 
nomic functions  of,  293-98;  and 
the  distribution  of  capital,  295; 
and  marketing  of  low  grade  secu- 
rities, 296;  interrelations  with  fi- 
nancial structure,  298;  panic  of 
March,  1907,  521 
Stockholders'  "rights,"  155 
Surplus,  accumulation  of,  required, 

553 
Syndicate  {see  Underwriting) 

Token  coins,  84 

Trade  acceptance,  definition  of,  164; 
illustration  of,  165;  similarity 
to  promissory  notes,  168-69 

Trade  credit,  135;  in  agriculture, 
654-56 

Trade  draft  {see  Trade  acceptance) 

Transfer  agent,  309-11 

Traveler's  checks,  372 

Treasury  notes  of  1890  diffi- 
culties with,  27,  loi;  redemption 
of,  102;  legal  tender  of,  104; 
amount  of,  103 

Trial  of  the  Pyx,  71 

Trust  companies  and  bond  dis- 
tribution, 238;  chap,  on,  301-26; 
and  corporation  finance,  306-15; 
as  transfer  agent,  309;  and  cor- 
porate reorganizations,  312-13; 
as  registrar,  311;  as  fiscal  agent, 
313-15;  as  custodian  of  securities, 
316-22;    regulation   of,    322-23; 


growth  and  importance  of,  359- 
60;  and  agricultural  credit, 
65 1 ;  commercial  banking  features 
of,  table,  726-27 

Trust  receipt,  414,  illustration  of, 

415,  and  bank  acceptance,  602 
Two-name  paper,  384-85 

Underwriting,  function  of,  diagrams, 
136,  218;  228-33;  joint  account 
arrangement,  229;  syndicate,  2; 
230-32;  participation,  232;  de- 
pendence upon  commercial  banks, 
232,  297;  relation  to  stock 
exchange,  297;  and  financial  con- 
centration, 761-64  {see  also  Con- 
sortiiun  of  international  bankers) 
United  States  deposits,  374 
United  States  notes  {see  Greenback 

currency) 
United  States  treasurer,  84,  85 
United  States  Treasury,  and  bank 
note  issues,  370,  501;  relation  to 
money  market  502-5;  and  finan- 
cial crises,  530-31;  and  Federal 
Reserve  notes,  589;  and  Federal 
Reserve  System,  614-16 

Victory  loan,  634-35 

Warehouse  Act,  of  United  States, 

399 
Warehouse  receipts,  nature  of,  397; 

loans  on,  397;  illustration  of,  400 
War  Finance,  and  Federal  Reserve 

System,  624-31 
"  War  paper,"  592;  origin  of,  628-30 
Working    capital,    2,   8,    132,  137; 

charts  on  134,  136,  760 


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